I bond soars but fixed rate drops
By Laura Bruce • Bankrate.com

The inflation-fighting savings security known as the I bond got a big boost in its semiannual tuneup. The bond will pay an annualized earnings rate of 6.73 percent for the next six months. The rate consists of a 1 percent fixed rate, which applies for the 30-year life of the bond, and an adjustable rate of 5.7 percent. (The slight discrepancy is due to the way the composite is calculated.) The adjustable rate is reset every Nov. 1 and May 1, based on an average of the Consumer Price Index from the previous six months.

A nearly 3 percent increase in the CPI from March to September pushed the I bond from its previous composite rate of 4.8 percent. But a major consideration for consumers who may be lured by the hefty new rate is that the fixed rate -- the component that stays with you as long as you own the bond -- is a mere 1 percent. That's down from the previous 1.2 percent. It means that you are guaranteed to earn a fixed return just 1 percent above inflation. If inflation heads south, future composite rates will nose dive and you could find yourself owning a long-term bond with a return that falls short of other fixed-income investments such as certificates of deposit.

You must hold the I bond for one year before cashing it, and you'll pay a penalty of three months' interest if you sell before five years. There's no way of knowing what the May 2006 rate will be, but if you think inflation is likely to continue the I bond may be a decent deal. If the spring 2006 inflation adjustment keeps the I bond's return right about where it is now you'd still reap slightly better than 5 percent if you sold the bond after one year and paid the penalty.

But, Dan Pederson, author of "Savings Bonds -- When to Hold, When to Fold, and Everything In-Between," says six months of average inflation will cut your net gain to about 4 percent.

"If we have normal inflation of 2.2 percent to 2.5 percent, then the second six-month rate will drop to 3.2 percent to 3.5 percent when you add the 1 percent fixed rate. The blended rate for the year would be about 5 percent with a net of around 4 percent after the penalty."

The other savings bond that is adjusted on the same timetable as the I bond is the Series EE bond. Its new rate is 3.2 percent, down from the previous rate of 3.5 percent. The EE is a fixed-rate bond -- buy now and you'll receive 3.2 percent, annually, for as long as you hold the bond. The U.S. Treasury, which prices the bond, bases the EE rate on 10-year Treasury note yields.

"It's also adjusted for features unique to savings bonds such as the tax-deferral features, the option to redeem savings bonds at any time after the initial holding period and the option to buy at a fixed rate for six months," says Treasury Department spokeswoman Brookly McLaughlin.

EE bonds issued before May 1, 2005, receive a semiannually adjusted earnings rate pegged to 90 percent of the average five-year Treasury yields for the previous six months. Those bonds are grandfathered to that formula, and folks who hold EE bonds issued between May 1997 and April 2005 will earn an annualized 3.61 percent for the current six-month period.

You can learn more about the government's decision to change the EE to a fixed rate bond by reading Bankrate's "Savings bond buyers may be offered a lousy deal." And for more on understanding I bonds, check out "Series I bond: Your protection against inflation."