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  • iBonds Revisited

    Posted by Carl from Chicago on January 5th, 2010 (All posts by )

    I have written about iBonds on this site in the past and wanted to re-visit them (due to deflation the interest return on all iBonds went NEGATIVE recently which was interesting news).

    IBonds are US government bonds and thus they are the “benchmark” for low risk debt instruments. IBonds have the following characteristics (which are well-summarized at the US Government web site here):

    – a “fixed” interest payment that is set when you buy the bond. This component is set at the time that you make the original purchase and is constant throughout the 30 year life of the bond (or until you redeem it). This component has ranged from a high of 3.6% back in 2000 (before the government basically went with a zero-rate policy to prop up the markets) down to ZERO in the middle of 2008. It currently has a rate of 0.3%
    – every 6 months you get a return equal to the inflation rate. This rate (for comparison purposes I am multiplying it by two to get an annual rate, although it is a tiny bit more if you are into statistical details due to compounding) has ranged from 5.7% (2.85% * 2) back in 2005 to NEGATIVE 5.56% in mid 2009 (which meant that EVERYONE who owned an existing iBond was getting NO interest for 6 months, because even if you bought one of those “golden” 3.6% ibonds back in 2000 that annual rate was less than this negative inflation component
    – If you buy an iBond now, you get an annual rate for the next 6 months of 3.36%, which is basically the 0.3% “fixed” rate plus a bit more than 2 times the current inflation rate of 1.53%
    – Your existing iBonds take the “fixed” rate from the year that you bought them plus 2 times 1.53% to determine the current yield; so if your rate was 1.55% (mid 2006 vintage) then you are currently earning about 4.6% / year
    – There are also some tax advantages. You don’t need to pay state or local taxes on the iBond interest that you earn until you redeem the bond (you have the OPTION of reporting interest annually, which could be a good idea if you are buying them for a child and they are in a low interest rate bracket, but this is beyond the pale for the current discussion)
    – One disadvantage is that you can’t get access to your funds for 12 months after you buy a bond issue. If you redeem them within 5 years, you lose the last 3 months of interest. After 5 years, there are no penalties

    I wrote about iBonds most recently when their interest rate paid on ALL iBonds regardless of fixed rate component went to ZERO. I was interested in following up with them to see the current fixed rate being offered as well as the interest component.

    Basically, iBonds are a GREAT deal right now. They provide inflation protection for when interest rates increase (which will drive inflation), they are the lowest risk class bond available (when the Federal government can’t float debt any longer we are all in big trouble), and they provide deferral opportunities for taxes.

    In reviewing other debt alternatives (something I will come back to in additional posts), right now a 2-3 year CD is yielding 1.5% to 2% / year. This is less than the iBond is yielding now (although it is guaranteed, while the iBond can fluctuate and go down if there is deflation, although not below zero). Other government securities are in the 2% range (or less) and then you need to go up the risk ladder a bit to get even 3% or 4%.

    The Federal government knows this and they want to keep the iBond program relatively small, I guess, because they are limiting the purchase of iBonds to $5000 / year. You can go online to treasurydirect.gov to purchase them (it is very easy to do) and they will sweep the $ out of your bank account. If you really put your thinking cap on you can buy some for you and some for your spouse but in general for most the $5000 cap will apply unless you have a comprehensive estate plan in place. For a while you used to be able to buy $30,000 / year of iBonds which in hindsight was a great purchase plan but they cut it back accordingly.

    All in, iBonds should be considered by anyone looking for an effectively zero risk component of their savings. Right now banks and CD’s are offering almost nothing so this is a very viable alternative. You can’t get at your money for 12 months but since your purchases are only limited to $5000 / year this likely isn’t a significant deterrent.

    Cross posted at LITGM and Trust Funds for Kids

     

    6 Responses to “iBonds Revisited”

    1. Daedalus Mugged Says:

      I think you are mistaken about how the variable component of the I-bonds work, and therefore how great a deal they are. If they did indeed work how you describe I would quickly max out my, my spouse, and just about every relative’s contributions. But I don’t think you are correct, and if I am mistaken, please correct me as well. I would have some investements to make.

      My understanding is that you will get the inflation rate, plus the fixed component. So a very modest (currently 0.3%) real return over inflation, if the CPI accurately reflects inflation (there is a lot of academic debate, but I am on the side of it that the gov’t stasiticians systematically underestimate inflation in their CPI calcs). You seem to be mistaking the ‘doubling’ of the 6 month inflation to the annual rate as actually getting 2x the inflation rate.

      So for example, the current available annual yield is 3.36%. And it is 0.3% real plus 3.06% annual yield of the inflation component. And that 3.06% annual rate is double the 1.53% 6-month change in the CPI. You are not getting double the CPI, only the annualized verion of the last 6 month CPI.

      So for example, if you bought an i bond now, for the first 6 months you would get a 3.36% annual rate for 6 months, or 1.68% actual for 6 months, and assuming the inflation rate is identical in the next 6 months, you would get another 1.68% for a 3.36% yield in a 3.06% inflation environment. You would then pay (federal) taxes on 3.36% return. If you are in the 25% tax bracket, your after tax yield would be 2.52% in a 3.06% inflation environment. A negative after tax real return. The way you present it, you seem to believe that it is double the inflation rate, and is there fore a great deal. It would be a great deal if it were true, but it does not appear to be. I expect a material increase in inflation over the medium term 3-5 years running out past 10 years. I am trying to figure out how to protect myself and my assets. I don’t believe this is it. This is a decent way to keep some cash reserves in a vehicle that may do a better job of keeping up with inflation than most other forms of cash…but it is not an investment. It is a negative after tax real return vehicle, but with perfect credit and great liquidity after 5 years. It may have a modest place in people’s portfolios, but only a modest one (portion of emergency/cash reserves), and that is why I believe the Treasury limits it in size.

    2. Carl from Chicago Says:

      Thank you for the comment.

      I did not mean to imply that you are getting 2x the rate of inflation. You are getting the inflation rate as calculated by the CPI, recalculated twice / year. With the modest “base” rate of 0.3%, you are getting about 3.5%, and as you stated, after tax (which is deferred, by the way) you are ‘negative’ when compared against inflation.

      However, virtually all zero or no risk fixed income items are negative in terms of inflation. Treasury instruments with 2 year maturities are yielding under 2%. CD’s with 2-3 year horizons are generally at about 1.5%, with some of the weakest banks offering about 2%. All of these strategies are ALSO below the iBond rate listed above, and also ‘under water’ when it comes to keeping up.

      If you believe in inflation, as you indicated above, then in fact NOW iBonds are good investments. The inflation component will keep being revised every 6 months, and if inflation comes (as measured by the CPI), then your rate will go up too.

      There is a limit of $5000 / year on iBonds so they won’t be the “core” of anyones’ portfolio. But they can be a nice addition.

      Later I will write about more fixed income opportunities; with the government pegging interest rates near zero nothing is keeping up with inflation, without taking on more risk, which is a separate topic.

    3. Robert Schwartz Says:

      Here is my problem. The yield gap between tips and fixed bonds of the same maturities is ~230 — 260 bp. Therefor, one of two things is true.

      Either we are about to return to inflation very soon, which means that fixed bonds are over-priced or that the real risk free long term rate is not the 3% — 4% that we learned about in school, it is really more like half that.

      Or, There is no inflation on the horizon and tips are over-priced.

    4. Carl from Chicago Says:

      I think TIPS are a totally different critter than the iBonds. iBonds are kind of a sideshow from a total portfolio perspective, if you have a decent amount to invest, although putting aside $5000 / year of after tax money as a portion of total savings is a lot to the average person. You used to be able to put in up to $30,000 / year in iBonds which meant that they could represent a big portion of the total portfolio for a wide range of savers / investors (and up to $60,000 if you were married and set them up separately).

      I would have to research TIPS much more to even start to talk about them. I am going to go through the other fixed income options and blog about them at Chicago Boyz and at the other sites as part of doing my own research.

      But in general I believe that there IS inflation on the horizon and that I don’t want to lock myself into a rate in the 2% – 4% range (with about 4% at the 30 year level) since I think that at some point interest rates are going to go up and inflation too. I am not an expert so not an investment advisor just looking at this from the perspective of an average investor.

    5. Daedalus Mugged Says:

      Carl,
      Thank you for the reply, and clearing my misunderstanding of what you meant about the 2x inflation. One other thing. My understanding was that state and local taxes could be deferred until maturity, but interest for federal taxes are reported and due annually to the IRS. I don’t think you can defer the federal taxes, which I perhaps mistakenly think you are implying you can.

      As I said, my perspective is that this is a decent vehicle for the emergency/cash reserve portion of ones portfolio (despite being a negative real return, as you point out most cash like instruments are), but is not an ‘investment’…it is steadily losing real value. You cannot build wealth this way. Only store it…and slow but not stop the erosion of inflation.

      I look forward to your future posts on fixed income. For now, I am looking largely to short term (<3 year, to mitigate long term inflation risk) lower tier investment grade to higher tier non investment grade bonds (BBB to BB type, that I view favorably). I am also thinking about some floating rate leveraged loan type ETFs/mutual funds that don't hedge the floating rate component. Any that you recommend?

    6. Carl from Chicago Says:

      Daedalus thanks again.

      You clearly can defer the income on them for Federal and State tax purposes. I do this every year since I have been investing in iBonds for years (except that there was less income this year, since for 6 months of the year none of my ibonds received any interest at all since the rate was set to zero).

      You can CHOOSE to also report income annually to the IRS – you can choose to do this in the case where the beneficiary is a minor who may be in a low tax bracket.

      I am going to write on CD’s through a brokerage next and then move through some other fixed income vehicles.

      Frankly it is kind of bleak right now. For any kind of decent return (above inflation, as you point out) you need to take some risk. That isn’t good. The current interest rate environment is punitive for savers.