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  • Inflation, iBonds, and Spurious Accuracy

    Posted by Carl from Chicago on March 14th, 2008 (All posts by )

    At Life in the Great Midwest one of the most popular posts is an analysis I prepared on iBonds. iBonds are offered by the Federal government and information can be found at their official site www.treasurydirect.gov.

    iBonds are a fixed income security where the principal is guaranteed by the US Government, which basically means no risk. If you invest $5000 (their current annual maximum) you will get your $5000 back at maturity, unless the US Government collapses in which case we likely will have other problems. In addition to receiving your principal back, the securities pay a “base rate” that is between 1% – 3% depending on when you purchased them (currently at 1.2%) and you receive a semi-annual inflation component which tracks the CPI… this component is now 1.53% for six months or approximately 3.1% for the year. Thus 3.1% plus 1.2% equals a rate of approximately 4.3%, which is pretty good right now since Treasuries are yielding 2-3%.

    You used to be able to buy iBonds at a rate of up to $30,000 / year per SSN (or $60,000 for a married couple) but now the Federal government has limited it to $5000 / year per person since they were a great deal compared to other alternatives (I am speculating on this, but they did reduce the amount you could purchase). With the rate down to $5000 / year they are good for gifts or kids but not a serious investment vehicle anymore.

    Back to iBonds – the reason that they were interesting is that you could clearly see your “rate of return” above inflation – 1.2% / year, and the rest was basically keeping up with inflation. This rate is sobering; a lot of the gains you get on your investments is really just keeping up with rising prices; 1.2% guaranteed before taxes isn’t really enough to even keep the lights on unless you have millions of dollars at work.


    As you can see in these pictures, the rates of many goods and services are increasing far beyond the 1-4% annual rate (semi-annual times 2) that you can see that they use at the government site for calculating iBond returns. There is a whole body of thought criticizing the CPI and how they measure inflation but in general they exclude food, fuel and most services and assets, which means that they miss everything that makes the cost of living so high nowadays.

    I think a lot of blog readers (unless they live in NYC or London) will probably be surprised about how much it costs to smoke or park via valet in a congested part of Chicago; even I was surprised by the $41 valet cost. Also – how the heck did they come up with $41? You’d think either $40 or $39 (to make it seem cheaper) would be a logical price point; but $41 is just annoying.

    The gap between inflation as calculated and the “real” cost of living is so vast that the government’s figures, with their tiny 2 decimal place accuracy ratings, are like Dan’s famous annual “the chains” posting showing how idiotic the feigned accuracy in football measurements really are.

    Cross posted at LITGM

     

    2 Responses to “Inflation, iBonds, and Spurious Accuracy”

    1. Jonathan Says:

      Welcome to the 1970s.

    2. Gordon Says:

      I would make one modification to the above. It is possible to buy $10k/SSN of ibonds per year. The limit is $5k/SSN through TreasuryDirect, but you can purchase an additional $5k/SSN in ibond paper certificates, purchased through any bank. $10k/year isn’t a fortune, but it is enough to create some protection against financial disasters that don’t take out the US government. Think of it as an eternal $10k that, becasue of the inflation protection, will almost certainly retain most of the buying power of $10k today. I can pay a lot of my annual bills with $10k of today’s dollars, so $10k I put into ibonds this year should be significant to me in 30 years when I am (if lucky) drawing social security.

      The advantage of ibonds relative to TIPS is that the fixed interest + inflation premium compounds untouched by the tax man until cashed out. TIPS (unless held in a tax deferred account like an IRA or 401K) create taxable interest payements and taxable growth in the principle (unless inflation is negative) each year. In addition, the interest payments from TIPS are not accrued in the value of your TIPS holding (unless you purchased a TIPS mutual fund). If you own TIPS directly, the interest is distributed twice a year, and you must then actively do something with it to achieve the equivalent of the compound interest effect that you get without effort from ibonds.

      So, in short, ibonds are a nice hands-off way of preserving a small but meaningful quantity of capital against the risk of inflation over a medium to long (up to 30 years) timeframe. They are not a complete investment solution, but no single investment should be.