Strategy: Gov't I bonds as a good 11 month investment: 4%+ returns likely

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

Think the mention - jdopple I think - was suggesting waiting until as close to the next interest rate announcement as possible - requires a guess from then short term rates to whether the next rate period is going to be around 4.8.

However if the money is in emigrant or ing I think it's quite arguable that you'll lose more with the 4.8-Emigrant difference than you might make by doing a good job guessing in a few months.

I bought some at the end of July, but I usually manage to float them out the 5 years - and with the tax deferral will probably keep them past that point.

Good info. The only thing I didn't see mentioned (please correct me if I'm wrong) was one negative regarding buying I-bonds the day before new rates are announced. While it will get you interest for the whole month, this will lock you into a particular fixed rate for the life of the bond. Historically, this fluxuation may be anywhere from 0.0 to 0.5%. So short term it might not be a big deal but over 10-30 years it could add up being stuck at a lower fixed rate.
I bought some I-bonds on Oct 31, 2003 and they were not processed until Nov 1st.(made the same mistake as a previous poster) My current rate is 4.7%, since the fixed rate at the time was 1.1% and not 1.2%.
Anyone who bought these in May-Oct 2000 is sittin on a nice 7.201 % right now thanks to that high 3.6% fixed rate.

My comment about wating till the last minute, was specifically targeted at a 1-year hold. Obviously, if you plan to hold for the 5 years or even 2-3 years, waiting is not as important.

With 1 year rates already as high as 4,5 (Corus), Buying I-bonds and cashing them in before a few years have passed is NOT such a good deal. The fixed rate is very low, and if rates escalate, then short term bank CD's will ALSO escalate. The 2 month hit is about .8 %, assuming another 4.8 combined rate, So you will make less than a 1 year CD, excluding state tax exemption.

Hot New Rates!
The new numbers are out, and the semiannual component for the May-Oct period (calculated as the increase from CPI-U Mar'05 to Sept'05) is 2.85% semiannual or 5.69% annual. With the current fixed rate of 1.2%, this means that a bond bought between now and the end of the month will pay 4.8% for the first 6 months, and then 6.92%(!) for the next 6 months.

A Modified Strategy - 14 months
Since the rates are so good, the best short term strategy is to think of this as a 14 month investment (rather than 1 year like I suggested in OP). Buy at the end of this month (get a free month's interest), hold for the next 11 months and earning 12 months interest at the above rates, and then wait 3 extra months before cashing out, for a total of 14 months. The extra 3 months waiting at the end guarentees that the 3 month penalty for cashing out doesn't come out of those nice 6.9% months, but rather from whatever the new inflation rates are for the next period (we don't care about the new numbers, since we are forfeiting that interest anyway).

Annual Returns of 5%+ are Easy!
What we have here is a 14 month investment, paying one year's interest at an average rate of approximately 5.86%. Even ignoring the state tax issue, this corresponds to an annual return of 5.00%, which is a full 1% better than ED's 4% savings account and 0.5% better than the best 1-1.5 year CDs currently paying around 4.5%.

Compute Your Own Returns
Since I bonds are state tax and local tax free, they are even better for those subject to these income taxes. Look up your marginal state and federal income tax rates, and use the (approximate) formula below to compute an annual pretax equivalent return:

Annual Pretax Equivalent Rate =~ 5.86%*(6/7)*(1 - Federal Tax)/(1 - Federal Tax - State Tax)

The 6/7 (or 12/14) factor approximately corrects for the annual return from a 14 month strategy that only earns 12 months of interest. For example, if you are in the 30% Fed and 10% state tax brackets, this strategy pays the equivalent of 14 month CD paying 5.84%. Depending on your state tax situation, the annual pretax returns from this range from about 5% (no state tax) to over 6% for those with high local, state and federal rates.

Buy Now or Later?
If you buy before the end of this month, you'll have a guarenteed excellent return as described above. If you wait until November, you might benefit from an increase in the fixed rate component of the I bond, currently at 1.2%. While there is no formula for how this rate is set, it has generally moved together with the Fed's interest rates. From the history over the past few years, I would expect the fixed rate to either stay the same or maybe rise a little (0.1 or 0.2%).

The tradeoff to waiting is that you are no longer able to enjoy the older 4.8% rates, and instead are betting on the inflation in next 6 month period (Sept'05-Mar'06). If you are considering holding your I bonds long term, this might be a more important consideration. For the short term, I would recommend buying now. If the inflation is high during the next 6 month period, you can keep holding your I bonds and enjoy the high rates until the I bond return no longer looks attractive relative to other short term fixed rate products.

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 intersting.

Don't forget that I bonds are exempt from state and local taxes. They also grow tax deferred.

Xerty, I came up with the exact same strategy you did. Another bonus with the 14+ month strategy is that the earliest you will cash in is Jan. '07, thus no federal tax will be due until 2007!

when it changes to the new inflation rate, is the new inflation rate good for the next 6 months as well, or does it adjust to be only good until the end of that 6 month period.

If bond purchased in october 2006, the inflation rate in may is used for 6 months(10/05-3/06). When that 6 month timeframe is done in March would the Novmeber inflation rate be good from April 2006 through sepetember 2006???

Xerty

Pardon my ignorance but how did you confirm what the next semi-annual rate is going to be. I thought that the semi-annual
I-bond rates were not announced until November 1.

I get it now. Thanks for the explanation whodini. I somehow missed that other thread.

I have one question about the I bonds.

"11. Is there a limit on how much I can invest each year in I Bonds?

Yes. You can buy up to $30,000 worth of paper I Bonds each calendar year. In addition, you may also purchase up to $30,000 in electronic I Bonds through TreasuryDirect. The purchase limitation for Series I Bonds isn't affected by purchases of Series EE Bonds.
"

Does this mean a person can do a total of $60K worth of I bonds or only $30K of one or the other? I've been shopping around for CD rates in the past few days, with 5+%, I think I know where I am putting my money.

wearetheborg said: Are any of you guys thinking about moving to TIPS ?

I have a bunch of 1.6% I bonds, and my tax bracket this year is quite low. Thinking of dumping them all.

I'm definitely moving to TIPS! I think some inflation-indexed securities are good to have, for those worst-case high inflation scenarios which seem to come and go every couple of decades. But at the current fixed rate that the Treasury sets for I bonds in comparison to TIPS real rates, I can't justify buying I bonds for myself (it would depend on specific tax situation). For almost two years now, I have only redeemed I bonds and bought TIPS (although I have substantially reduced my inflation indexed overall amount).

As far as the 1.6's, it would depend on your tax situation, but I would only cash them out for TIPS if TIPS were moving above 2.5% again, and I'd probably stick to 5 or at max 10 year maturity TIPS as a former I bond investor. The "variable maturity" feature of I bonds, 1-30 years, is still something nice to have.