I bonds still in a trough

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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.

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.”

I bonds still look good

Despite a nonexistent return after inflation, I bonds are looking pretty good to a lot of fixed-income investors right now, says Cynthia Petzold, CFP and principle of CommonWealth Financial Planning in Roanoke, Va.

“You go to your bank and your savings account is earning 0.1 percent. And your certificates of deposit? You lock them up for five years at a magnificent 2.4 percent. There just haven’t been a lot of places to go to put your cash lately,” she says.

Even with a zero percent fixed-rate component, “these I bonds do play a part in the portfolio, simply because there’s not a whole lot out there that can give you at least a hope of capturing some of the inflation increases without taking on additional risk,” Petzold says.

McBride concedes 4.6 percent looks attractive at first blush but cautions that settling for a real return of zero percent over the long term ultimately means getting shortchanged. If you have your heart set on a nearly risk-free return, McBride recommends a short CD ladder instead. It gives investors more flexibility to reach for a positive real return as rates improve.

What’s ahead for I bonds the next time their rates change on Nov. 1? If history is any indication, very little will happen. Even if yields on other government securities, such as Treasuries, go up, the fixed component likely will remain uncompetitive, McBride says.

“Until that fixed-rate component becomes meaningful, I bonds become an also-ran,” McBride says. “It’s not an appealing investment until you start to see a compelling return on that fixed-return component, and there’s no assurance that you will.”