iBonds

Recently I have been writing about investing in secure securities (i.e. where you can’t lose money, except in extremely unlikely scenarios). I focused on purchasing CD’s that are insured by the FDIC and constructing a “ladder” of varying maturities through your brokerage account. The return on these CD’s is much higher than is currently being offered by US Treasury securities and has other advantages such as convenience and simplification of statements.

There is another form of safe investing that is easy to do and risk-free (assuming the US Government does not collapse). This is called an “I Savings Bond” or “iBond”.

ABOUT IBONDS AND CALCULATING THE INTEREST RATE:

iBonds are issued by the US Government. iBonds can be purchased at www.treasurydirect.gov after you set up an account and provide appropriate information, at zero charge. The iBonds are issued electronically and the money moves electronically which makes them very convenient, as well.

Unlike virtually all other types of bonds, the iBond interest or “coupon” rate is tied to the inflation rate as measured by the US Government. Virtually all other bond instruments either adjust their coupon rate according to how interest rates move (short term rates mainly determined by the Federal Reserve, long term rates a combination of short term rates and market sentiment) or the price adjusts (i.e. if you have a bond paying 6% interest and the market price moves to 5%, you could sell that bond for a gain in the market and it would be priced “above par”), depending on the type of bond.

The iBond has 2 components; a “fixed” interest rate that has varied between 0% (low) to 3.4% (high) over the last several years and a semi-annual interest rate component tied to the rate of inflation that changes every six months. ONCE YOU BUY AN IBOND THE FIXED RATE NEVER CHANGES, but the semi-annual component tied to inflation adjusts every six months (thanks to an alert reader for catching this error in a previous post). iBonds have a thirty year maturity.

The “fixed” interest rate component has had different base rates since the iBond program was started in 1998. The “fixed” component was 3.4% in 1998 and then dipped as low as 0% for bonds purchased between May 1, 2008 and October 31, 2008. The current fixed rate component on iBonds is 0.7% for bonds purchased between November 1, 2008 and April 30, 2009. If you buy iBonds today that “fixed” component will stay the same until you cash them in or they mature, 30 years from now.

The “variable” interest rate component is determined by the inflation rate, divided by 2 (the semi-annual inflation rate). The current semi-annual inflation rate is 2.46%, or 4.92% for the year. Thus iBonds purchased between November1, 2008 and April 30, 2009 pay about 5.64% (it is slightly higher than 0.7% + (2.46% * 2) because of compounding interest).

Note that if you buy different issues (i.e. $5,000 / year) of iBonds, your fixed rate may vary by year, but the “variable” component will be the same for each issue over every six month period. I realize this is confusing (it confused me, for what that is worth) and here is a link to the government site where they try to explain it.

IBOND LIMITS AND REDEMPTIONS:

An individual can purchase up to $5,000 / year in iBonds. If you are married and want to go into details 2 individuals can purchase $10,000 / year in iBonds under 2 SSN’s, electronically. You can also go physically to a bank and buy “paper” iBonds up to that same limit (this can be done at a bank). You can also purchase iBonds for kids (i.e. for college or a trust account) under their SSN up to the same limits.

UPDATE – THE LIMITS HAVE BEEN REDUCED TO $5000 / YEAR AS OF 1/1/08.

You can’t sell back your iBonds in the first year after purchase (unless there is a natural disaster or some other unique circumstance in your area); thus they are not “cash and cash equivalents”.

If you sell back your iBond within 5 years of purchase, you lose one quarter of one years’ interest. After 5 years you can redeem your iBond with no penalty.

IBONDS AND TAXES:

The advantage of iBonds is that you can defer Federal taxes on iBonds until they are redeemed, and they are immune from state and local taxes. Deferring taxes in this manner is useful because the interest that would have been taxable grows at a compound rate for the life of the bonds. In some circumstances (using them for education), the interest isn’t taxed at all when the bonds are redeemed (you should read about these at the government site, I am not an expert on the various criteria, but they seem pretty generous). Overall, iBonds receive very favorable tax treatment. IBonds might be considered as part of your college savings solution; they essentially have the same treatment as 529 accounts (you aren’t taxed on your earnings, assuming they are used for qualified education purposes). If you wanted a guaranteed portion for college you could use IBonds and get a guaranteed (albiet low, if the markets are booming) return.

IBONDS AND INFLATION:

iBonds provide protection against future inflation. If you own a bond with a fixed coupon at, say 6%, and inflation moves from 3% (current rate) to 5%, it will significantly erode the value of your bond (the price in the market will be lower if you want to sell it prior to maturity; you will receive your same coupon payments in the meantime). For iBonds, however, they automatically adjust to the inflation rate, and thus they provide a “hedge” against changes in inflation. For this reason it may be good to have them in your portfolio, because they are not correlated with your other investments (this is a good thing in “portfolio theory” terms).

Note that inflation as computed by the Treasury may not match actual inflation; they measure a basket of goods and don’t count services like college costs nor do they count real estate (an asset). Thus YOUR rate of inflation could be much higher (or potentially lower) than the rate quoted for your iBond.

SUMMARY:

You may want to look into iBonds, especially if you are in a high tax bracket or the AMT. iBonds have very favorable tax treatment, more so if your state has a high tax rate. iBonds are also attractive if you are saving for college for yourself or your children; the interest may be non-taxable if used for certain purposes.

iBonds don’t come with any expenses and are easy to buy and sell. You don’t have to deal with a broker, you can just do it all online at the Federal government site.

IBonds are currently paying VERY competitive rates – 5% – 6% depending on when you made your initial purchase – but this could easily go down if inflation slows with the cooling economy. CD’s are paying 4% or so for a couple year maturity. The brokerage CD’s have an advantage in that they can be sold in the open market while the iBonds are “stuck” for one year. Money market (which is paying below 2%) is immediately available (but less well protected, in extreme cases).

The 1 year “lock up” and 5 year “interest penalty” of one quarter means that you shouldn’t use this for your emergency fund. They might be a good component of a balanced investment program, especially if inflation rises which will erode your other bond and fixed rate investments.

Cross posted at LITGM

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