I-bonds turn into a short-term investment
By Greg McBride, CFA • Bankrate.com

I-bonds, the inflation-indexed savings bonds, were designed for buy-and-hold savers. The exemption from state and local taxes, the deferral of federal taxes until the bond is cashed with proceeds exempt from all taxation if cashed for education and semiannual return adjustments to compensate for inflation are all supposed to appeal to conservative, long-term investors.

But it isn't working out that way, not for the next six months anyway.

The repricing of the I-bond on May 1 to 4.66 percent is eye-catching. The return boost provided by inflation makes the I-bond unquestionably attractive over the short-term, especially when compared to other risk-free investments.

But cutting the fixed return component from 1.6 percent annually to 1.1 percent removes much of the I-bond's viability over the longer haul, at least for those who buy between now and the end of October. The fixed return is what an investor is guaranteed to earn above the rate of inflation over the holding period.

This situation is ironic given the recent extension of the minimum holding period from six months to one year in an effort to discourage investors from investing on a short-term basis. Investors continue to incur a three-month interest earnings penalty if the bond is cashed within the first five years.

The uptick in inflation between September 2002 and March 2003 at a 3.54 percent annualized pace accounts for the bulk of the return currently being earned. To the benefit of savings-bond investors, this number includes the volatile food and energy sectors that are often stripped out of other inflation barometers.

But let's look at recent history. The last year that inflation exceeded 3.54 percent was 1990, when prices climbed 6.3 percent. It is a safe bet that as oil prices settle in post-Iraq, so too will the rate of inflation that includes both food and energy.

Some risk to a surge in inflation exists with interest rates at 41-year lows, but the Federal Open Market Committee has ample ammunition to ward off such a threat. In fact, the statement from the May 6 Fed meeting indicates concern over disinflation or possible deflation instead.

Over the past 10 years, the rate of inflation, including food and energy, has averaged just 2.5 percent annually. With the fixed return component on the I-bond now just 1.1 percent, it is entirely possible that an investor would earn approximately 3.6 percent per year over the long haul. Such a number sounds great today, but is not so appealing in a higher rate environment.

For evidence, we need look no further than three years ago. In May 2000, yields were nearing a five-year high after a series of Fed rate hikes beginning in June 1999. The average one-year certificate of deposit yield at the time was 5.42 percent and the average five-year CD yield was 6.06 percent.

In a year when inflation tallied 3.4 percent, in after-inflation terms an investor would have earned roughly 2 percent on the one-year CD and 2.6 percent on the five-year CD. Better yet, the after-inflation return on the five-year CD climbed in the two subsequent years to 4.5 percent and 3.6 percent as inflation decelerated to 1.5 percent in 2001 and 2.4 percent in 2002.

So while the intent may be to discourage investors from using I-bonds as short-term investments, the reality is likely to be far different. As energy prices have a more modest impact on inflation in the future, the returns on I-bonds will drop and many investors who bought between May and October 2003 will head for the exits. Even if the fixed-return component is ultimately bumped up, that won't do anything for investors buying I-bonds now.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Personal Finance Advice channel on Bankrate.com.