BondsOnline Advisor

Say "I" for Inflation Protection

Stephen Taub

For the past few months, I have discussed several ways bond investors could heavily shield themselves from potential rises in inflation and interest rates by pointing out the advantages of Step-Up Notes and Treasury-Inflation Indexed Securities, also called Treasury Inflation-Protected Securities, or just plain TIPS.

This time I?m going to discuss another sometimes overlooked offering?I Bonds.

Offered by Uncle Sam, these relatively new securities are low risk, and very liquid. And, best of all, they protect your savings from inflation.

You can even purchase them online through TreasuryDirect, and you don?t even need to plunk down much money. The minimum investment is $25 when buying through TreasuryDirect.

The current rate through October is 4.66%.

I Bonds are an accrual-type security. This means interest is added to the bond monthly and paid when the bond is cashed. They grow in value with inflation-indexed earnings for up to 30 years.

The earnings rate of an I Bond is a combination of two separate rates.

First, there is the fixed rate of return. It remains the same for the life of the bond.

Second, in a twist from most other bonds, there is also a semiannual inflation rate. This changes every six months.

The fixed rate of return is announced by the Treasury Department each May and November. The fixed rate of return announced in May of a given year is the same over the entire life of the I Bonds you purchase between May 1 and October 31 of that year and the fixed rate of return announced in November of a given year applies to the entire life of I Bonds you purchase between November 1 and April 30 of the following year.

The May 2003 fixed rate was 1.1%.

The semiannual inflation rate is also announced each May and November by the Treasury Department. The semiannual inflation rate is based on changes in the Consumer Price Index for all urban consumers (CPI-U), which is reported by the Bureau of Labor Statistics.

The most recent semiannual inflation rate was 1.77%.
The semiannual inflation rate is combined with the fixed rate of an I Bond to determine the I Bond's earnings rate for the next six months.

What happens if there is deflation? In other words, the CPI-U is negative? Then the CPI would be subtracted from the fixed rate of return.

For example, if the fixed rate of return is 2% and the CPI declines by 0.6%, the yield on the Series I bond would drop to 1.40%. However, the Treasury has said it will not allow the earnings rate to go below zero.

I Bonds earn interest for up to 30 years.
Earnings are exempt from state and local income taxes. Federal income taxes can be deferred for up to 30 years, or until redemption or other taxable disposition, whichever comes first.

In addition, if you qualify, you can exclude all or part of the interest on I Bonds from income as long as the proceeds are used to pay for tuition and fees at eligible post-secondary educational institutions.

You can buy I Bonds in eight different denominations, ranging from $50 to $10,000.

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 limit for Series I Bonds isn't affected by purchases of Series EE Bonds.

Investors who purchase the I Bonds must hold them for at least six months before they can be redeemed. A three-month interest penalty is imposed on bonds that are redeemed before five years have passed since the date of issue.
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.