The Finance Buff

Around mid to late April and October, there is a twice-annual game of guessing what the next I Bonds rate will be. I Bonds are a type of savings bonds issued by U.S. Treasury to retail investors. The interest rate on I Bonds are linked to inflation and adjusted every 6 months. The Treasury Department also arbitrarily determines and announces the fixed (”real”, above inflation) rate on new I Bonds on May 1 and November 1 of each year. Because the inflation adjustment is known around the 20th of April or October, the game becomes guessing what the next fixed rate will be and speculating whether one should buy now or wait until after the announcement. See this post for an example of this guessing game.

I Bonds used to have good fixed rates until April 2003. Good rates plus built-in tax deferral made them very appealing. Since May 2003, the Treasury Department cut the fixed rate significantly. For a while, they were still competitive to savings account and money market funds. However lately yields on savings accounts and money market funds increased because of Fed rate hikes, while I Bonds’ fixed rates were kept low. I Bonds fixed rates also lagged the rates on its sibling TIPS by a long shot. Except for a short-term opportunity in October 2005 induced by inflation spike caused by Hurricane Katrina, I Bonds issued after May 2003 just haven’t been that competitive lately (older I Bonds are still OK). But the game of rate guessing still goes on.

The inflation adjustment for the next 6-month period is 3.1% annualized. I think the fixed rate will be cut again from the current 1.4% to 1.2%. That’s the opposite direction to what the rates on TIPS have been going, but I don’t have high confidence that the Treasury Department will give the retail investors a fair deal based on TIPS rates. Rates on 5-year TIPS have risen from 2.25% in end of April 2006 to 2.58% as of today. A 1.2% fixed rate will take the I Bonds composite rate to 4.32%, allowing the Treasury to claim that it’s still competitive to other bonds — 5-year Treasury note yields 4.74% now. Tom Adams at Savings Bond Advisor wrote in an update to this post:

As of Oct 18, when we learned the next inflation component will be 3.10%, a fixed rate in the 1.4% area, plus or minus .1%, looks more likely.

However even 1.5% real rate is nothing to write home about when 5-year TIPS is yielding close to 2.6%. I will buy TIPS and continue to ignore I Bonds.

More on the mechanics of buying TIPS in a separate post tomorrow. Come Nov. 1 let’s see if my guess on the I Bonds fixed rate is good or not.

Related Posts:

• I-Bonds Rate Guess for May 1, 2007
• I-Bonds Fixed Rate Pre-Guess for November 2007
• No Change in I Bond Fixed Rate