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Savings-Bonds-Alert: Series I Fixed Rate - Effect of Compounding

Wednesday, October 06, 2004

Series I Fixed Rate - Effect of Compounding

I am wondering what determines the fixed rate portion of the Series I Savings Bond (not the inflation adjustment). Also, given the historically lowest fixed rate, isn't this a bad time to invest in these bonds? With the interest rates likely to go up, wouldn't that increase the likelyhood of fixed rate going up! Tom's first response Although there's no specific formula for the fixed-rate portion of the I bond rate, it's clear the Treasury sets it after reviewing recent market rates for TIPS, the Treasury's marketable inflation protected security. When the fixed rate goes up on future Series I bonds, there's no reason you can't redeem the bonds you have and buy the new ones with the higher rate. There are some disadvantages - loss of tax deferral and a three-month interest penalty if the older bond is less than five years old, but I suspect we'll still see times when it makes sense to pay the penalty if inflation takes off. Click here for a complete analysis of Series I versus Series EE Savings Bonds. Questioner's response Thanks for your response. Your website is very informative. In comparing various interest instruments I wonder if you have taken the following into consideration - interest on Savings Bonds is compounded bi-annually whereas interest on savings accounts like the one at ING compounds daily. Will the impact of compounding more than offset the higher interest rate of I-bonds (by let's say 1.5%). I guess I could do the math, but I'm wondering if you have ;) Tom's response While more frequent compounding is always better, the differences are minor. Banks use a concept called APR (annual percentage yield) to make equal comparisons between investments with different compounding periods. You never see an APR for Savings Bonds rates in the future because the rates adjust every six months. You can't predict in advance what the interest rate will be for the second six-month rate period, so you can't calculate a forward-looking APR. But to give you some hard numbers, here's the APR of a 5% interest rate with various compounding periods:
  • 2 (semi-annual) 5.06%
  • 4 (quarterly) 5.10%
  • 12 (annual) 5.12%
  • 365 (daily) 5.13%
At lower interest rates, the difference is even less. Click here to visit the premier independent web site for Saving Bond owners.


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