### Inflation jumps; new I bonds could exceed 7%

The initial six-month rate for Series I Savings Bonds could exceed 7% after November 1.
The inflation component of the I bond rate will be 5.69% for rate periods beginning from November to April. This represents the annualized change in the Consumer Price Index between March and September, which was announced this morning.
Using the current I bond fixed base rate of 1.2% creates a composite I bond rate of 6.92%. If theTreasury increases the base rate for new I bonds to 1.3% or more, the rate on new I bonds will exceed 7%.
Older I bonds will pay from 6.72% to 9.39% during their next six-month rate period. I bonds issued from May 2004 through April 2005 have the lowest base rate - 1.0% - and will earn the 6.72% rate. I bonds issued from May through October 2000 have the highest base rate - 3.6% - and will earn the 9.39% rate.
Even after the early withdrawal penalty, I bonds purchased before the end of this month will earn a guaranteed one-year APY (yield after compounding) of 4.13%. This is a combination of six months at the current composite rate of 4.80% plus three months at 6.92% (the other three months of interest are lost to the penalty). This is well above the best current 1-year CD rates.

## 19 Comments:

Thanks for the note. I really find value in your book by the way (the one I own, anyway - perhaps you have more than one out by now).

Anyway, great minds think alike, though my numbers are a bit different than yours:

http://www.theunknownideal.com/2005/10/september_consumer_inflation_s.html

Best to you. Keep 'em comin'.

With the inflation component being so high, do you see the possibility of them reducing the fixed component?

I guess the question for potential I-bond buyers is whether to buy now or wait till November?

It's difficult to demonstrate based on historical numbers, but the primary indicator the Treasury must be using to set the I Bond fixed rate portion is the equivalent market rate for TIPS, the Treasury's big-boy version of I-Bonds.

That rate has been higher recently, so I don't see how they could lower the fixed rate for I Bonds.

My best guess is that the next I Bonds will have a fixed-rate of 1.30 or higher. I don't think it will be over 1.50, though.

This is a great site, I do have a question on the last portion of your post. You mention I bonds purchased before the end of this month will earn a guaranteed one-year rate of 4.11%. This is a combination of six months at the current composite rate of 4.80% plus three months at 6.92%.

If I buy a bond before the end of this month. would the rate for october be 4.8, the rate for the six months after that be at the new rate? or is it that if you buy a bond before the end of this month the rate is 4.8 for the next 6 months?

thanks

I bonds purchased before the end of this month will earn a guaranteed one-year rate of 4.11%Can you also calculate a guaranteed return for 13, 14, and 15-months? 6 months of 4.80%, 4,5,6 months of 5.92%, and 3 months of 0%. Would that be correct?

When you buy a Series I Savings Bond, you get the then-current rate for that month and the five following months.

For each following six-month rate period after the first one, you get a rate determined by your base rate and the last announced inflation rate.

When you buy bonds in October (or April), your rates lag the Nov 1 (or May 1) rate announcements by 5 months.

I hadn't thought of it, but you

candetermine rates for 13, 14, and 15 months. If you keep the bond you will earn an unknown rate, but if you cash it, the unknown rate doesn't matter because you forfeit it to the early withdrawl penalty.The math to calculate this is a little complicated because you have to adjust for the additional months being more than a year. To get a true "annual percentage yield", or APY, you also have to adjust for compounding, which I forgot to do in the original article (since corrected).

Here are the APYs: 12 months, 4.13%; 13 months, 4.34%; 14 months, 4.52%; 15 months, 4.67%.

Seems like the best deal would be the 15-month option. Buy late in this month and redeem early January 2007. In that case it almost becomes like a 14-month CD. And you don't have to worry about paying Fed taxes on the interest until 2008.

Tom,

You say the APY for 15mo is 4.67. I get a higher number even without compounding. Here's how:

((6*4.8)+(6*6.92)+0+0+0)/15 = 4.688

Wrong?

Also, if I buy at the end of month and sell at the beginning, then don't I get 2 mo's of interest without actually having invested i.e. I can earn interest in a money market acct for those 2 mo's (and get interest from the bonds).

Also, my optimistic guess is the fixed rate will be between 1.4- 1.6 based on the TIPS rates over the last 6 mo's.

Thanks for clarifying and a very helpful site.

Ok, you asked for it. The math for calculating APY goes like this:

CPY = compounding periods per year

FV = future value (value at end)

PV = present value (value at beginning)

Y = number of years

APY = CPY * ( ( (FV/PV)^(1/(Y*CPY)) ) -1 )

In the case of 15 months, the number of years, Y, is 15/12 or 1.25. The number of compounding periods per year is 2.

You can use anything for the present value, PV, but the Treasury uses $12.50 so that all denominations of Savings Bonds earn increments of the same amount.

The FV, then, is the original amount plus the interest earned: $12.50 + 0.30 + 0.44 or $13.24.

The 30 cents come from $12.50 * 4.80% * 6/12 (because you only earn this rate for six months out of 12).

The 44 cents is (12.50 + 0.30) * 6.92% * 6/12

Now, plug in all those numbers and do the math and you get an APY of 4.674%

Before there were computers, nobody calculated APYs. Before there were spreadsheets, only large organizations calculated them. But now anyone with the formula can do it. APYs allow you to exactly compare investments with different terms and compounding periods.

Any comments on this article:

www.bankrate.com/brm/news/sav/20051019a1.asp

First time I have seen a cut in the fixed rate predicted.

When is the fixed rate for I bonds usually announced? If the fixed rate does go down, would I still have time to buy in October before the new rates go into effect?

The source for the Bankrate article is Dan Pederson, author of a 1999 book on Savings Bonds.

Dan's theory is that the Treasury bases the fixed portion of the I Bond rate by looking at all interest rates and deciding how much they have to pay to be competitive.

My theory is that the Treasury bases the fixed portion of the I Bond rate by looking specifically at the yield curve for 5-year TIPS (Treasury Inflation Protected Securities), the big-boy version of I Bonds.

If Dan is right, the fixed portion will go down. If I'm right, the fixed portion will go up.

We'll know who's right on November 1. Unfortunately, that's too late to buy October I Bonds.

Dan's theory is that the Treasury bases the fixed portion of the I Bond rate by looking at all interest rates.

My theory is that the Treasury bases the fixed portion of the I Bond rate by looking specifically at the yield curve for 5-year TIPS.

Before I found either Pederson or your articles, I was trying to figure out the exact same thing on my own. First, I compared historical I-Bonds composite rates with 5-year treasury yields, and it didn't correlate well at all. Especially in May 2003 when I-Bonds composite was 4.66% and 5-yr treasury yields was only 2.66%. Then I compared historical I-Bonds to 5-year TIPS yields, and that was much closer, only a 0.16% STDEV over the past 5 years.

At first, one might think the Fed would be crazy to be offering I-Bonds at 6.9%, but you have to look at the long-term picture. When inflation drops back to historical levels, so will the composite rate. The 5-yr TIPS yield takes that into consideration. I believe you're right on.

At first, one might think the Fed would be crazy to be offering I-Bonds at 6.9%, but you have to look at the long-term picture.Wouldn't they still get buyers if they offered even 5.9% as a current rate? Even at that price they could get a lot of short-term buyers.

Why should banks and brokerage firms get a better deal with TIPS than individual investors get with Series I Savings Bonds?

The TIPS rate is determined in the open market and it is what it is.

The I Bond rate should be based on the TIPS rate, not on the Treasury's ability to screw small investors if it wants to.

So, when do the new rates get posted. It's November 1st and they are still showing the old rates on Treasury Direct.

The new fixed rate dropped to 1.00%. The Treasury posts the new rates at 10 am ET. I guess now we know the Treasury does not consider market conditions for setting the rate ... unfortunately.

The EE bond rate is also down from 3.5% to 3.2% even though the yield on the 10 year treasuries that they are based on have been inching up ever so slowly. Perhaps the Treasury is trying to make savings bonds less attractive and wanting to get everyone to buy markatable treasuries through their new integrated service on TreasuryDirect?

Another thought on TIPS ... for someone buying now, the large inflation hike of the last six months would have already occured, i.e. the TIPS are already adjusted for the CPI-U increase. Therefore, as an alternative investment, someone could not cash in on this inflation hike on TIPS anymore at this point as compared to the I bond which is based on previous rates. Could it be that the drop in fixed rate is somehow connected to the Treasury's forward-looking prediction on TIPS?

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