Reader mail tells me that I Savings Bonds are one of the most misunderstood good deals available to the investing public. They offer a competitive return, can be held for up to 30 years, and can be redeemed in relatively small amounts at no cost. While they are being held, the interest they earn is accumulated tax-deferred.
• Unlike mutual funds that invest in bonds, the value of I Savings Bonds
does not fluctuate. It only goes up.
• Unlike most tax-deferred annuities, the penalties for early redemption
are not severe.
• Unlike brokered CDs, the value of the investment does not fluctuate
with interest rates.
So let's start at the beginning and go through the basic questions:
What are I Savings Bonds? Unlike EE Savings Bonds, which earn and accumulate tax deferred interest at a rate pegged to the rate on 5-year Treasury obligations, I Savings Bonds offer an inflation protected rate of return based on the Consumer Price Index and a premium over the inflation rate. Like EE Savings Bonds, the interest earned is accumulated tax-deferred.
How is the yield on I Savings Bonds determined? Every six months the basic interest rate may change. The basic interest rate is a premium that is added to the rate of inflation. Bonds purchased in the current period (November to April), are earning at a 6.73 percent annualized interest rate based on a 1 percent premium and a 5.70 percent inflation rate.
Bonds purchased in other periods will be earning at different rates because there were different basic interest rates in other periods. These rates varied from a high of 3.60 percent for bonds purchased in the May to October, 2000 period to a low of 1.00 percent for bonds purchased in the November 2005 to April 2006 period. Since the rate of inflation is added to each basic interest rate, ALL the I Savings Bonds issued in earlier periods are currently earning more than 6.73 percent. Bonds purchased in the May to October 2000 period, for instance, are currently earning a whopping 9.40 percent.
Why is the basic interest rate so much lower today than it was when the bonds were introduced? Think of it as marketing. The bonds were new and unfamiliar when they were introduced in 1998. Today, people understand that the basic rate is a premium over the inflation rate. The 1 percent basic rate bonds available today are yielding 6.73 percent, well over yields on bank CDs, tradable Treasury securities, and mutual funds that invest in government securities.
Will the current yield decline? It all depends on the inflation rate. If inflation declines, the composite interest rate (basic rate plus inflation rate) will decline. The real return over the rate of inflation, however, will be fixed at whatever the basic interest rate is when you buy the bonds. If you are concerned about future inflation, these bonds are likely to give you more protection than conventional bonds.
Is a 1 percent premium over inflation a good rate? According to Ibbotson Associates, intermediate and long term government bonds earned a premium of 2.4 percent a year over the annual inflation rate between 1926 and 2004. U.S. Treasury bills earned a premium over inflation of only 0.7 percent over the same period.
Investors, however, could experience long periods when inflation exceeded what they were earning on their conventional bonds. I Savings Bonds will always earn a premium over inflation. In addition, the interest is tax-deferred. As a consequence, I believe they are superior to Treasury bills and competitive with conventional bonds. They are particularly superior to most mutual funds and variable annuities that invest in government bonds because mutual fund and variable annuity expenses reduce their advantage. The average intermediate term government bond fund, for instance, has an expense ratio of 1.09 percent. This would reduce the 2.4 percent premium over inflation to 1.31 percent--- and the yield isn't tax deferred. The average intermediate bond sub account in a variable annuity has a total expense burden of 1.90 percent, reducing the 2.4 percent historic premium over inflation to 0.5 percent.
When you do the math against competing vehicles, I Savings Bonds look very attractive.
Do I Savings Bonds have any other advantages? They are particularly useful for retirement planning and taxes. Since they can be redeemed at their accumulated value at any time after five years without penalty, they offer risk-free access to sums of money in very flexible amounts.
In addition, your tax liability will be on only the accumulated interest portion of the redeemed amount. A $100 I Savings Bond purchased in November of 2000, for instance, will be redeemable for $139.88 this April. A retiree can access the full amount but will need to pay income taxes on only $39.88 in interest.
In comparison, mutual fund returns are currently taxable. Variable annuity withdrawals are 100 percent taxable income until the accumulated income is exhausted.
Where can I buy I Savings Bonds? The surest way is to use the Web. Enter your ZIP code in a site listed below and it will give you the phone number of the nearest Federal Reserve Bank. You can also set up an account online. It is also possible to buy them through a regular bank, but many readers who have tried say they are not available through that channel.
On the Web:
Enter your zip code and find the Federal Reserve Bank for help and transactions
Composite earnings rates for I Savings Bonds with different issue datesRate on I Savings Bonds purchased in this period------------------------------------------------------------------------------------------------
Personal finance writer Scott Burns is syndicated by Universal Press. His twice weekly column appears in newspapers from Boston to Seattle. He is the Chief Investment Strategist for AssetBuilder, Inc. Readers can register at
www.scottburns.com. Questions/comments can be posted directly. They can also be sent, without registration, to
scott@scottburns.com. Questions of general interest will be answered in future columns and on this blog.
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