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U.S. adds fixed-rate return to new 'I-series' savings bonds

November 3, 2008 |  8:48 pm

The U.S. Treasury recently had seemed to be on a mission to drive Americans away from buying savings bonds.

So a change announced on Monday came as a surprise: In its semi-annual adjustment of interest rates on inflation-indexed savings bonds, the government said it would pay a 0.7% fixed annual rate on newly purchased securities, in addition to the inflation adjustment.

Combining the fixed rate and the inflation adjustment, new I-bonds, as they’re called, will earn interest at an annualized rate of 5.64% for the next six months -- a hefty return compared with yields on other government securities.

Some background on I-bonds, which the government has been issuing since 1998: Historically, they’ve earned a combination of a fixed rate, which holds steady for the 30-year life of the bond, and the inflation rate as measured by the consumer price index. The inflation component is adjusted each May 1 and Nov. 1, and the Treasury also has the option of changing the fixed rate on new bonds on those dates.

Mlkseriesibond With the CPI soaring this year because of energy and food costs, the inflation component has surged as well. In May, the Treasury decided investors were getting enough of a return from the inflation adjustment to warrant eliminating the fixed rate on newly issued securities.

That isn’t a big deal at the moment, with the CPI still elevated. The inflation adjustment alone will pay all I-bond investors a 4.92% annualized return over the next six months.

But the lack of a guaranteed fixed rate on bonds issued between May 1 and last Saturday means investors who bought those securities will earn nothing at all if inflation drops to zero, or if deflation (falling prices) takes hold.

Why would the government reinstate a fixed-rate component for new I-bonds? Dan Pederson, author of the book "Savings Bonds: When to Hold, When to Fold," speculates that the Treasury figured that investors might rush to cash in bonds that have no fixed rate if inflation begins to ebb.

I-bond holders can cash them in after holding them a minimum of 12 months. If the bonds are held less than five years, investors forfeit three months’ worth of interest.

My two cents: I think I-bonds still are useful as a portfolio diversifier -- a buffer in case inflation rockets in the next few years. And the reinstatement of the fixed rate boosts the bonds' appeal. I-bonds are easy to buy directly from the Treasury, and you can defer taxes until the bonds mature. (They're subject to federal income tax but not state tax.)

By contrast, the government has made Series EE savings bonds far less attractive than I-bonds or conventional Treasury securities: On Monday, the Treasury cut the annualized fixed rate on newly issued EE bonds to 1.3% from 1.4% on bonds sold in the previous six months.

Even if inflation falls to 1%, you’d earn 1.7% a year on new I-bonds, beating the new 1.3% yield on new EE bonds. Only at a sustained annual inflation rate under 0.6% would EE bonds beat I-bonds, Pederson notes.

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