April 21, 2009 in Investing

The government’s inflation-fighting I bond will hit rock bottom May 1 when the new earnings rate is expected to be zero. That will be a first for the bond since its inception in September 1998.

A new I bond is issued every May 1 and Nov. 1. Each is issued with a fixed rate that sticks with the bond for its 30-year life, and a variable rate that is adjusted every six months to compensate for inflation. The two rates combined make up the earnings rate. The current I bond, issued Nov. 1, 2008, has a fixed rate of 0.7 percent and a variable annualized rate of 4.92 percent for a composite rate of 5.64 percent.*

To price the I bond, the Treasury looks at the previous six months of inflation data as calculated by the Consumer Price Index. Thanks to four months of deflation during the past six months, the economy is running at a rate of -5.4 percent annual inflation, says Dan Pederson, author of “Savings Bonds: When to Hold, When to Fold and Everything In-Between.”

“The I bond is guaranteed to never have a negative accrual, but it does not guarantee that you’ll get a positive accrual. It means that if there is a negative variable component that exceeds your fixed rate, the government will simply net you out at zero for that six months and that is what will happen to every single I bond out there for this next six months.”

Greater volatility

The highest fixed-rate issued on an I bond was 3.6 percent in May 2000. Since the -5.4 percent inflation rate exceeds that, the combination of the two numbers leaves those bond holders with -1.8 percent for the upcoming six-month period. They’ll simply be netted out at zero percent.

Pederson doesn’t expect that the government will do much with the fixed rate in May. He says it might raise it just a tiny bit to take some of the sting out of the goose egg, but that there’s really no reason for them to do anything.

This whiplash scenario from the November 2008 bond earning an annualized 5.64 percent to the May 2009 bond earning nothing is due primarily to the fantastic rise and fall in energy prices over the past year, says Pederson.

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“I bonds have greater volatility because they’re only measuring a six-month period. If we look at the past 12 months we’d see slight deflation of maybe 0.1 percent or 0.2 percent,” he says.

Don’t rush to sell

Pederson cautions bond holders against selling the bonds based on this May disappointment.

“I bond holders need to hold on and understand that this is a one-time six-month blip. If you have high fixed rates on your I bonds, do not run out and cash them because you suddenly got one six-month period at zero percent. You’ll still get that fixed rate plus inflation going forward, and I think we’ll find over the long term that this period is an abnormality.”

When to buy

Consumers have to do their own homework and determine whether the I bond has a place in their portfolios, but you may want to consider buying the current I bond before April 30.

You would get the current 5.64 percent annualized rate for the first six months of ownership. For the second six months, you’ll get whatever is issued May 1 — presumably 0 percent. I-bond rules state that you must hold the bond for 12 months prior to cashing, and that you’ll pay a penalty of three months’ interest if you cash out before five years. It’s the last three months of interest that would be deducted which, in this case, would be zero. Therefore, you’d receive 2.82 percent for holding the current bond for one year. If that beats your CDs and money markets, it may be worthwhile.

If you think plenty of inflation is coming down the pike and you want to hold an I bond for more than 12 months then buy now. You’ll lock in the 0.7 percent fixed rate and get the presumably higher inflation adjustments in the years ahead. Steer clear of the May bond, unless for some reason you’re sure the government will raise the fixed rate.

*The announced fixed and inflation components don’t quite add up to the composite rate because of the way the composite is calculated.

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