Update - new I bond rates are 0% fixed, this deal is over as of 4/30/08!
This is an update to my old thread, Strategy: Gov't I bonds as a good 11-14 month investment.
Hot New Rates!
The new numbers are out, and the semiannual component for the Sept-Mar period (calculated as the increase from CPI-U Sept'07 to Mar'08) is 2.42% semiannual or 4.84% annual. With the current fixed rate of 1.2%, this means that a bond bought between now and the end of April'08 will pay 4.28% for the first 6 months (based on the old numbers), and then 6.07%(!) for the next 6 months (based on the new numbers).
A 14 months Strategy
Since the rates are so good, the best short term strategy is to think of this as a 14 month investment. 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% 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 4.4%+ are Easy!
What we have here is a 14 month investment, paying one year's interest at an average rate of approximately 5.17% Even ignoring the state tax issue, this corresponds to an annual return of 4.42%, which is abou 0.5% better than the best savings accounts right now and better than the best 1-1.5 year CDs both of which currently paying around 4%.
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 =~ 5.17%*(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 5.16%. Depending on your state tax situation, the annual pretax returns from this range from about 4.4% (no state tax) to 5.4% for those with high local, state and federal rates. There's a small correction to this formula if you itemize your state taxes (see the old thread) which makes the result a little lower than the above formula would suggest.
Options are good
There are lots of "free options" in holding I bonds once you get past the illiquid first 12 months. You can cash them whenever you want thereafter, subject to the last 3 month's interest as a penalty if you cash them before 5 years. Of course it sucks to lose 3 months interest, but remember that the only reason you'd likely cash them is that the next 6 month's interest (which you will know in advance) is poor. So at least you only lose 3 months of poor interest. In addition, at the time you have to make this decision, you'll have about 3 months of additional information towards the next 6 months' inflation rate so if that's looking particularly promising you might choose to hold through a low 6 month period, all other things being equal. If things keep looking good, maybe you make it to 5 years and get a "free" 3 months extra interest at that point, which is a nice bonus.
Tax breaks are good too
In addition to being state and local tax exempt, I bonds are Federal tax deferred. This lets you benefit from tax free compounding while you hold them. This means you might time their cashing in a low income year to minimize taxes due. They also could be partially or totally tax free if cashed in a year you pay significant educational expenses.
Macroeconomic forecast looks good
At least in the short term, I expect significant continued inflation. The Fed's low rate policy has weakened the dollar relative to other currencies, driving up the price in dollars of real physical goods (like oil and food) bought in the worldwide market. This contributes to inflationary pressures and until the Fed starts raising rates (not likely in an election year with a shaky stock market), I would expect this trend to continue. Of course this doesn't impact the 14 month strategy, but makes it more likely that the next 6 months also have fairly high inflation, and so the bonds would continue to be worth holding into the next year or so.
Buy Now!
If you buy before the end of this month, you'll have a guarenteed excellent return as described above. If you wait until May, you risk that the rate component of the I bond, currently at 1.2%, could drop to something lower. While there is no formula for how this rate is set, it has generally moved together with the Fed's interest rates. Since interest rates have been slashed in the past 6 months and TIPS are paying almost nothing, I'd expect a drop, possibly a large drop, from the current 1.2% fixed rate.
Limits?
The old limits were $30K per SSN bought online through Treasury Direct, and another $30K bought in paper form from a bank. The Treasury recently cut these limits to $5K online and $5K in paper form per SSN. There are some reports of people being still able to order $30K of bonds online, but that's a YMMV at this point. I believe that I bonds bought jointly for another person in their SSN are taxable to the person who physically cashs them. At least this was true of paper bonds I cashed recently, meaning that you can buy paper bonds with all your trusted relatives (jointly but using their SSN), and not have any tax headaches for them if you hold them and eventually cash them. I am less sure whether this would work through the online system and invite comments by current users.
