investing

I bonds still in a trough

Penny on stock chart
Highlights
  • The I bond variable rate jumps while the fixed rate stays at zero percent.
  • Yields on government debt instruments such as Treasuries have been low.
  • If your aim is a nearly risk-free return, a short CD ladder might be better.

It's a weird time for fixed-income investing when I bonds' fixed-rate component is set at zero percent for the second time in a row and it still looks at first glance like a good investment.

The new I bond's fixed-rate component, announced May 1, will stay at zero percent for another six months. The I bond's variable rate jumped from 0.37 percent to 2.3 percent, a leap of 193 basis points. In addition, the fixed rate on Series EE bonds issued between May and October 2011 climbed to 1.1 percent from 0.6 percent.

On the I bonds, the fixed rate will apply to all of that class of bonds issued between May and November, and it will stick with the bond throughout its 30-year life span. In November, a new fixed rate will be announced.

The variable rate component changes every six months. A new variable rate is announced in May and November based on inflation changes and is applied to all outstanding I bonds.

Consumer Price Index jumps

The increase in the variable comes as a result of a jump in the Consumer Price Index for all urban consumers, which rose from 218.439 in September 2010 to 223.467 in March of 2011, a six-month increase of 2.3 percent that puts the I bond's annualized return at 4.6 percent, for now.

That jump won't change the fact that I bonds are a subpar long-term investment, says Greg McBride, CFA, senior financial analyst at Bankrate.com. That's because buyers have to hold on to the bonds for at least five years to avoid a penalty, and during that time they have no hope of seeing their buying power grow at today's rate.

Still, I bonds will probably get some attention from savers, especially because other fixed-rate investments are so low, McBride says.

Why the fixed-rate component rate stayed at zero percent is another question. Yields on government debt instruments such as Treasuries are certainly low, following a massive flight to quality during the financial crisis, and inflation expectations have been low enough recently to send the real yield on a five-year Treasury inflation-protected securities, or TIPS, into negative territory.

The Treasury doesn't publish an explanation of how it sets the fixed-rate component, but one only has to look at historical rates on I bonds to see today's low rates are part of a long-term trend, McBride says.

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When I bonds debuted in the late 1990s, the fixed-return component was more than 3 percent, peaking at 3.6 percent in 2000. Even when interest rates were at a record low in 2003, the real return didn't fall below 1.1 percent.

But after that, I bonds grew less and less competitive with other types of fixed-rate investments. "Between 2004 and 2006, when the Fed raised interest rates 17 times and interest rates spiked, what happened to the real rate on an I bond? It went from 1 percent, to 1.4 percent," McBride says. "Even then, there was a real emphasis on cutting the legs out from under the I bond by reducing that after-inflation rate of return. It's been uncompetitive for years, and we first saw the zero percent mark all the way back in 2008 before the worst of the financial crisis."

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