iBonds… You’ll Get Nothing, and Like it (or not)

From time to time I have posted about iBonds as an investments. iBonds are interest securities backed by the US Government that you can purchase online or at a bank (I guess, although I have never tried that). The general attraction to iBonds is that their interest rate goes up as inflation goes up – which provides protection in times of rising prices (hence the “i” in the name – I originally thought it was tied to the “dot com” era). Here is an in-depth analysis that I wrote about iBonds in December, 2008, noting that the government had reduced the total amount that you could buy each year from $30,000 / person to $5000 / person. Note that you can’t LOSE money on iBonds unless the US government defaults, in which case we all have some big problems.

In short – there are 2 components to your iBond return. The FIRST part is the “fixed” interest rate that the US Government offers you. I bonds have been issued for about 10 years, and the “fixed” rate used to be as high as 3.4% / year which dropped as low as 0.0% (yes, that’s zero) but recently were bumped up to a negligible 0.1% rate. What this means is that if you bought an iBond years ago and kept it, that is a better iBond than one that you are buying today since the rate today is near zero. I think that the iBonds that I purchased over a couple year period have a rate near 1%, give or take.

The SECOND part of your iBond return is the variable component. This component takes into account inflation. Thus if prices are going up (you have inflation), then the interest rate that you receive will go up, as well. For the decade or so the iBonds have been in existence, this rate has been positive (meaning rising prices), providing an interest rate of between 1% and 6% or so.

Thus since iBonds have been created, the return that you could have gotten (depending on when you purchased the underlying bond) your return would vary from a fixed component of between 0% and 3% and a variable component of between 1% and 6% meaning that the “real” range of interest is between 1% and 9% overall.

TODAY, however, the new iBond rate has been unveiled… and since we are in a deflationary period (prices are going DOWN), for the first time, the rate of return on iBonds is ZERO (the interest rate can never go negative). The decline in real prices is -2.78% for six months per the government calculations, which means that it annualizes to -5.56%, so no matter when you purchased your iBond your return is ZERO, because even the highest iBond rates were about 3% or so they are all dwarfed by the -5.56% annual rate.

OUCH. It is never good to have an investment with a return of zero, especially when you purchased it explicitly for interest income (and to ensure you didn’t LOSE any money). However, the inflation rate will be adjusted in six months, and if prices are going up then, the interest rate will reset upwards.

I wouldn’t invest in iBonds now if you haven’t already bought some, especially because you are just getting this anemic 0.1% return as a base level. Check again when they announce interest rates for the next six months, which will be on November 1, 2009. I wouldn’t sell what you have, however, because you’d just have to re-invest the money in something else, and savings and checking accounts are generally yielding almost nothing now, as well, along with money markets.

Note – for those of you that don’t get the reference (probably those younger than 21 or so… of course it is from Caddyshack).