You know that fixed-income investors are hurting when the prospect of keeping up with inflation with minimal risk is pretty exciting.
Today, the Treasury announced I bond rates that will be in effect from Nov. 1, 2012, until May 1, 2013. Each I bond has two components that determine its overall yield. One is the inflation rate, which reflects the change in the Consumer Price Index for All Urban Consumers for the previous six months. This time around, that rate will be 0.88 percent.
The other component is a fixed rate, which tells you how much the bond will yield over and above inflation for the life of the bond. That rate is stuck at zero percent for the fifth time in a row.
That goose egg isn’t surprising, says Eleanor Blayney, CFP professional and consumer advocate for the CFP Board in Washington, D.C. Thanks to aggressive easing by the Federal Reserve and continued shakiness in the economy, real rates on short-term bonds are negative right now, meaning after you factor in inflation, they’re actually diminishing in value over time.
In the land of negative real returns, zero is king
Taken together, the Treasury’s announcement means if you buy an I bond today, you’ll earn an annual percentage yield of 1.76 percent for the next six months, at which point the inflation rate will be reset again to reflect whatever happens to prices in the meantime.
That doesn’t sound like much, but in a world where certificates of deposit are paying on average less than 1 percent annually to lock up your cash for five years, Series I savings bonds can look pretty good, Blayney says.
“It offers investors a way at least to keep up with inflation,” she says. “Right now, people are just looking at anything that gives them more than a money market return.”
I bonds are unique in that they offer a way for Americans to keep up with inflation without the risk of losing money, she says. Like all savings bonds, I bonds are explicitly backed by the federal government.
And while their zero percent real return isn’t ideal, if the economy recovers and better opportunities present themselves, they can be redeemed any time after a mandatory one-year holding period for a penalty of three months’ interest. That’s pretty tame compared to most CD early-withdrawal penalties, and it disappears entirely after you hold the bond for five years, Blayney says.
“Theoretically you’re not really making anything. All you’re getting is the inflation,” Blayney says. “But if we do see real rates go up, you could get out of (an I bond) without too much penalty.”
Alternatives carry risk
There is another government-backed investment designed to keep up with inflation, called Treasury Inflation-Protected Securities, or TIPS, but buying them these days is riskier, says Blayney.
That’s because it’s likely that prices of TIPS, like other bonds, will fall sharply if interest rates, currently held down by the Fed and the shaky economy, rise, Blayney says. Because I bonds can be redeemed directly with the Treasury at face value, they don’t have that risk.
“Suppose we got some real economic growth. You now have a bond that has zero percent, and you locked that in for the life of the bond. Other alternatives are looking pretty good to you, because you can get a real rate of interest somewhere else,” she says. “If you were to take a TIPS that had zero percent and you want to sell it because you want a higher interest rate, you’re going to take a hit on the principle.”
Still, I bonds do have some drawbacks, Blayney says.
Unlike CDs and many types of bonds, I bond yields aren’t paid via regular checks that come in the mail. They are an accrual-type security, meaning the yield is added on to the value of the bond, so you’ll only get it when you cash it in. If you’re an income investor, that can be a disadvantage.
Also, the Treasury limits the amount of I bonds a person can buy to $10,000 per person per year.
One way to get around those limitations might be to ladder the bonds the same way you would CDs, buying and redeeming I bonds at regular intervals to create an income stream, Blayney says.
One more handy feature: If you use them to finance an education, I bond earnings can be excluded from federal income tax, she says.