Edit: Updated for the new Nov '05 rates. I now advocate holding I bonds for an 11 month period. The deal appears to about as good as a 1 year CD, but with significant tax advantages especially to those with state or local taxes.

Intro
Suppose you've got some money just sitting in ING or Emigrant Savings or whatever, earning a decent 4% or so. Maybe your looking at 1 year CDs, paying about 4.5% or so. If you won't need the money for a year, I bonds appear to be a surprisingly good investment, even assuming you cash them in and pay the 3 month interest penalty. Not as good as previously (see my 10/14 post on buying at the end of October), but still decent.

Details, details...
Here are the main points of interest:

1. The main idea is that if you buy any time between November '05 and April '06 you'll lock in 6 months of the currently nice 6.73% interest rate.
2. Remember that early redemption causes the loss of the last 3 months of interest, so it matters less what the new CPI numbers will be come April.
3. Don't forget to buy the I bond at the end of the month, getting interest for the whole month, and redeem it on the 1st of the month. Hence a 11 month I bond investment earns interest for 12 months - 3 months penalty = 9 months, 6 at the known high rate and 3 months at an unknown rate.
4. Recall the I bonds are state income tax free, unlike your savings account.
5. After a year, you have a free option to cash the bonds (if savings rates rise and inflation is low), or continue to hold them. This can be reevaluated every 6 months when the new numbers come out, and you can always switch then if you want.

Accounting for all these factors, I ran some numbers to see how little inflation was required in the April CPI numbers to give the I bonds the same rate of return as the savings account. From this, you can decide how likely you think that inflation level is, and hence if I bonds are likely to be a better investment.

An Example, beating ED is easy!
For example, if you're in the 25% Fed, 5% State tax brackets, there is no difference between a 4% ED account and the I bonds held for a year if the CPI drops 0.25% during the Nov-April period! That's right, you need deflation during 2nd 6 month period to do worse, and when was the last time there was any deflation? If inflation is anything at all, you come out ahead. If the CPI is flat, you make the equivalent of a 4.2% savings account. If it's 1% annualized (ie 0.5% CPI increase during those 6 months), you earn the equivalent of a (fully taxable) 4.5% savings account. If it's the 5.7% annual rate that gave us the great 6.7% rate right now, it'd be like a taxable 5.9% savings account.

Compute your own Returns
Feel free to compute the breakeven point for your own situation or the equivalent taxable return given your favorite inflation prediction, using the two formulae below. (For simplicity, I dropped the small correction term in the I bond interest rate, which means that the real returns will be a tiny bit better than the formula say, and inflation can be a tiny bit lower to break even). Note that the formula for return below gives an annual return number, despite the actual investment being for only 11 months.

Equivalent taxable return = (3.9% + 0.27*Annualized Inflation) * (1- Fed Tax) / (1 - Fed Tax - State Tax)
Annualized breakeven inflation = 3.67*(Savings Rate * (1 - Fed Tax - State Tax)/(1 - Fed Tax) - 3.9%)

For example, if you're lucky to have no state income tax, you can see that you get 3.9% annualized if there is no inflation. Your return increases by about 1/4 of 1% for every 1% of inflation during the 2nd 6 month period. If inflation is 1% for that period, you get about 4.2%. So if inflation is 2.5% (a recent historical average), you get about 4.6% annualized.

With reasonable assumptions about average inflations rates, you get about 4.6% annualized - about equivalent to the best 1 year CD rates, and better than savings accounts. With any state or local taxes, the bonds become increasingly attractive. Don't forget the correction term in the above equation if you can deduct your state taxes on your federal taxes. This is the corrected version:

Equivalent taxable return = (3.9% + 0.27*Annualized Inflation) * (1- Fed Tax) / (1 - Fed Tax - State Tax + (State Tax)*(Fed Tax))

Guessing the CPI for May?
In judging the risk/return for yourself, I found these site, InflationData and TreasuryDirect (note the 2nd site gives historical semiannual inflation rates), somewhat helpful for looking up inflation figures. For reference, typical CPI inflation rates since '98 (when I bonds started) have been about 2.4% annually.

Buy Now or Later?
If you're a small investor or have already bought your $60K allocation of I bonds for 2005, you might as well wait until the end of April '06 when we'll be able to exactly predict the 1 year returns. However, if you think these bonds are attractive to you (esp. for those with state taxes), you might want to buy a large amount of bonds before the year end, and then still have your $60K allocation available next year when April comes around.

A final word about the free option to redeem after a year. If things look good (or even the same) come April, you can hold the bonds for another 6 months. There may be benefits from federal tax deferral to consider too, depending on your situation. If the bonds remain competitive for five years, you wouldn't even pay the 3 month penalty, which would be a nice bonus.

Further reading -
Savings Bonds as an investment: a FAQ and info thread, updated 11/03/04
Which is better: I-bonds Vs CD's
Keep in Government Savings bonds transfer to Emigrant?

Thanks Xerty. Some thoughts to ponder upon. I have both. My Emigrant money is meant to be more near-term. And I have I-bonds for a bit longer-term savings. I-bonds are a great investment.

UncleSam said:Also, I did not know that buying on 30th and selling on 1st gets you 2 extra months of interest. This seems too glaring an error on the part of the govt.

You get an extra month of interest when you buy on the 30th but you don't get an extra month when you sell on the 1st. OP is advising to sell the bonds on the 1st because interest accrues on the 1st of each month.

imo, this is a decision best left to the last possible moment you can still lock in the 4.8 rate (4 or 5 months from now). Between then and now, short rates WILL be creeping up, making the lock in less desirable, and you will have a much better notion of the new rate at that time.

Thanks, OP, for continuing a discussion and capturing some prior threads that add to the exchange among people searching for a safe place to rest a nest egg. Good thinking! Appreciate this. -Zer

honestly, i used to be a bond i-banker and i still prefer a REIT over bonds.

that's just me; i've had good experience with REITs.

New to the game:

Is it better to buy directly or go to you bank and buy it

Also i was about to buy a 100$ I bond to try it out, Today being the 30th it says the purchase date is the 1st. so basically im a day late from earning that month on interest correct?

Good thread, any more thoughts?

Tom

The i-bond 4.80% is more 'interest'ing than 4.25% -- as we are talking savings, not fast cash. Of course, if it's only a year's investment, then sacrifice of i-bond interest to cash out is a factor. -Zer docsoc said: Great thread. The best 12 month CDs are up to 4.25% ( just checked on bestcashcow). The I Bond is looking less and less interesting.

stash it in ing or something for now, and then wait until later in the month