May 1, 2010 - the Treasury has announced the new interest rates for I-Bonds. The fixed-rate attached to all newly issued I-Bonds for the next six months is 0.20%. The semiannual inflation-rate, used in computing the interest on all outstanding I-Bonds, is 0.77%. These two rates are combined into a composite earnings rate for newly issued I-Bonds of 1.74%.
Some background:
US Treasury Savings Bonds. We've all heard of them, and many of us got them as gifts when we were young. The old versions were paper certificates with a face value on them which was twice the price that folks paid for them. The computation of their values was complex and required lookups in government tables, usually at a local bank.
Unlike traditional bonds, US Savings Bonds are non-marketable Treasury securities. That means that you cannot sell them to someone else - they may be redeemed (usually, again, at a local bank), or they can be held. One of the consequences of this is that they are not subject to the same kind of interest-rate risk that typical bonds are subject to. Whether rates go up or down, it doesn't affect the price or redemption value directly, since there is nobody you can sell them to, and when you redeem them, you generally get back all your principal plus accrued interest.
Savings Bonds have been around since 1935 and have been offered in a variety of series, the earliest ones were A, B, C, and D. The Series E bonds was first offered in 1941 and became the famous "War Bond" during WWII - and became the world's most widely held security. Bear in mind that back then, very few people (relative to how widespread it is today) owned stocks or mutual funds. Nobody had an IRA or a 401k. Folks had savings accounts at their local banks, paid off their homes, and bought savings bonds.
The Series E bonds had an original term of 10 years, though they were set to earn interest for as much as 30 or 40 years. In 1980, it was replaced with the Series EE bond and the last Series E bonds will cease earning interest this year, in 2010. EE bonds are still being issued. Over the years, there have been other series as well: F, G, J, K, H, HH and most recently, the innovative Series I bond. In addition to the changes in the series of bonds, how their interest was calculated, how long they interest, changes to how these bonds were bought, held, and redeemed have taken place. Millions of people bought them through the Payroll Savings Plan, folks bought them in person at their local banks, and as of a few years ago, they became available in pure electronic form through the Treasury Direct program (which already existed as a way for people and institutions to buy traditional Treasury bonds electronically).
The I bonds represent a departure from other Savings Bonds in that the interest rate is built of a combination of a fixed "real" rate, fixed at the day of purchase and for the life of the bond - and a floating "inflation" rate which is adjusted every 6 months and based on the CPI-U, a measure of inflation published by the BLS. Other Savings Bonds have their interest rates set based on averages of the yields of regular Treasury securities. The idea here is that an I-Bond will protect the value of your investment from inflation.
How the I-Bonds work:
Every six months, in addition to adjusting the inflation portion of the interest rate for all I-Bonds, the Treasury adjusts the fixed-rate which will apply to all the I-Bonds to be issued for the next six months. Whatever the fixed-rate was on the day one buys an I-Bond, that fixed-rate will be used, in combination with the semiannual inflation rates released every six months, to compute the interest that the I-Bond will earn over the following six months. When you buy an I-Bond, you lock in that fixed-rate for as long as you choose to hold your I-Bond.
When the I-Bonds were first issued, that fixed-rate was as much as 3 to 3.6% between 1998 and 2001. The fixed rate now is 0.20%. It's actually been as low as zero % (for six months in 2008).
The actual interest earned on an I-Bond is computed as follows:
Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Tax considerations:
There are some great tax advantages that Savings Bonds offer. Interest earned on them is subject to the federal income tax, but the tax is generally deferred until redemption. That means that if you hold a Savings Bond, you don't have to pay taxes on the interest each year. Instead, the interest accrues and compounds and until you redeem the bond, you don't pay any taxes on that earned interest. All of the accumulated interest you earned is only taxed when you finally redeem the bond. This is a powerful tax advantage similar to the tax advantage offered by a deferred annuity or a non-deductible IRA contribution. And this is quite different from TIPS, the marketable Treasury Inflation Protection bonds (on which taxes must be paid annually, and which generally ought to be held in IRAs because of that). Savings Bonds get tax deferral without having to put them into any kind of special account.
Moreover, interest on Treasury Savings Bonds is generally not subject to state income taxes. This is especially nice in high-income-tax states like California.
Finally, under certain conditions the interest may be excluded from federal income taxes when the bond owner pays qualified higher education expenses (college) with the money. (This is a little messy, as there are phaseouts which depend on the taxpayer's modified adjusted gross income).
Redeeming the bonds:
Savings Bonds generally may be redeemed no sooner than 12 months after purchase. You should probably not buy them if you have any reason to think you're going to need your money back sooner than 12 months. After that, if you redeem these bonds less than 5 years after purchase, you lose 3 months of accrued interest (which may not be a big deal if the rate on them is low and you have a better alternative at that point).
So should I buy savings bonds?
As usual, it depends on an individual's specific situation. Savings Bonds in the context of an asset allocation decision are a very low-yielding cash-like investment. The closest similar thing is a CD, as the money is locked up for a limited period of time after which it may either be cashed out or left in place. The lockup is actually tighter than a CD for those first 12 months during which the Savings Bond cannot generally be redeemed at all, but after that, the cost to get out of it is fairly small.
Note, however, that CD rates right now (May, 2010) with maturities of one year or less generally have rates lower than current composite yield (1.74%) on newly issued I-Bonds. You have to look at 18 month or 2 year CDs to get rates higher than that, and those are still subject to state income taxes and do not get the tax deferral that I-Bonds get.
The fixed-rate on these bonds right now locks one into a very low real rate of return. And no matter what happens to interest rates or inflation, that fixed-rate won't change for the life of these bonds. If one were to buy them today with the very low 0.20% fixed rate, it might well be worth forgoing the 3 months of interest (and paying income taxes on accrued interest) to cash them out and buy new I-Bonds as soon as a year from now if the Treasury raises the fixed-rate (and you can tolerate a new 12 month lockup period).
Nevertheless, given the low total return on these right now, it may be worth looking at alternatives such as a short-term investment grade bond fund which has higher liquidity (no 12 month lockup) and higher current yields. The downsides to a short-term investment grade bond fund are that if rates go up, the fund may lose a little value (this is moderated by it being only short-term bonds), or if corporate defaults go up, the spread may widen (again, similarly moderated by the short term of the bonds), and of course, there are tax consequences and potential trading costs as well.
If you were lucky or smart enough to buy I-Bonds back in the period between 1998 and 2000, consider them as part of your asset allocation and unless you really have other needs for that money, consider hanging on to them as long as you can. The fixed rates from back then were quite high, and between then and now, you've accrued substantial interest -- which is continuing to compound tax-deferred. It was difficult in 1999 to believe that a 3% real rate of return was incredibly attractive, while the stock market was soaring and the internet bubble was inflating. But it was a fantastic opportunity and those who took advantage of it should be quite pleased with that choice. In contrast, today, with a real fixed-rate of 0.20%, they don't look nearly as attractive now as they did then.
Some helpful links:
Treasury Direct's I Savings Bonds Frequently Asked Questions
I Savings Bonds Rates (current and historical)
Savings Bond Calculator (finds the value of EE, E, and I Bonds you already own)