Don't hold off on buying I bonds
By Laura Bruce • Bankrate.com

Being a fixed-income investor is probably only slightly less frustrating than being a Cubs fan. If you've been counting on the inflation fighting I bond to salvage your fixed-income portfolio, well, as they say in Chicago, "Wait til next year."

The I bond's interest rate, which is composed of a fixed rate and a semi-annually adjusted inflation component, will be re-priced Nov. 1. Savings bond expert Dan Pederson, author of Savings Bonds: When to Hold, When to Fold, and Everything In-Between, says he expects the combined rate to plunge to 2.2 percent from its current 4.66 percent.

"If they leave the fixed component alone, which I think they will, then the combination looks like 1.1 percent for the fixed rate and 1.1 percent for the inflation-adjusted component," Pederson says.

Pederson reached his conclusion after reviewing the government's Consumer Price Index data, which is used to determine the I bond rate.

The current I bond has an inflation component of 3.56 percent. The latest CPI analysis pegs inflation at about 2.3 percent.

Pederson advises investors who are sitting on the fence, hoping the November I bond price will be higher, to jump in and buy now.

"The strategy would be to buy before Nov. 1. You receive the current I bond rate of 4.66 percent for the first six months. Then you get the rate published Nov. 1 for the second six-month period. If that rate is 2.2 percent, then for the year, you'll average 3.43 percent.

"If you decide to get out after a year and give up three months of interest, after the penalty you'll still net 2.88 percent. That's more than double what most money market funds are paying right now, and the interest is exempt from state and local taxes."

On the other hand, if you wait until after Nov. 1 to buy an I bond, Pederson says you'll likely get 2.2 percent for the first six months and then an unknown rate for the second period. You can't predict what the full return will be.

Here's how the I bond pricing works. Remember, the fixed component that's in effect when you buy the bond is the one you keep throughout; it's only the inflation-adjusted component that changes every six months.

If you buy the I bond before Nov. 1, say on Oct. 25, you would get the fixed rate of 1.1 percent for as long as you own the bond. You would get the 3.56 inflation component for six months -- until April 25. At that point you'll receive whatever inflation component is set Nov. 1, 2003. That inflation component stays with you for six months -- until Oct. 25, 2004, and so on.

The Patriot or EE is the other savings bond that is adjusted semiannually. It does not have an inflation component; its interest rate is pegged at 90 percent of the average yield of the five-year Treasury for the previous six months. Pederson expects the bond, which carries a current rate of 2.66 percent, to remain fairly steady, coming in somewhere between 2.5 percent to 2.75 percent.

"If an investor planned to hold a bond for five years or more, I'd give the edge to the EE," says Pederson.

"Historically, it has averaged 2 percent above inflation and, if you buy after November, the initial EE rate will be slightly higher than the I bond. So, if you're thinking for the long term -- five years or more -- the EE will slightly outperform the I bond that has a 1.1 percent fixed rate.

The fixed rate is the most important component if you're buying long term because that rate stays with you for as long as you own the bond. You should also be aware that you must hold the I and EE bonds for at least 12 months. If you sell before five years, you'll forfeit three months' interest.

Bankrate senior financial analyst Greg McBride agrees that until the fixed component of the I bond improves considerably, it is not a viable investment for someone with a multiyear investment horizon.

"The EE is clearly the better alternative. The EE is like a floating rate CD. As interest rates rise, so will the return on the EE bond. But you still have to hope that's enough to outpace inflation," says McBride.

"If you're looking at a five-year investment horizon, the high yielding CDs are a worthwhile alternative, even with paying state and local taxes and not being able to defer taxes."

If you plan on buying the I or EE bond, Pederson advises not waiting until the last minute. Make your purchases no later than Oct. 29 so you don't risk getting a November issue date.

For more information on I bonds, click here.