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Wednesday, February 10, 2010

Part 3: Series I-Bonds: Five Investments for High Inflation

My recent article titled "ECRI Global Inflation Outlook - Higher Inflation Ahead" showed that inflation pressures are building globally. In the United States, December CPI came in at 2.7%.

Just last week, ECRI, the Economic Cycle Research Institute, said "With the USFIG now advancing for ten straight months, underlying inflation pressures are in a sustained cyclical upswing, promising higher inflation in the coming months." Even in Japan, the threat of persistent Japanese deflation "continues to recede."

In this series of article I will discusses five investments that should do well in an environment of higher inflation. These are
  1. Part 1: Gold
  2. Part 2: Cash
  3. Part 3: Series I-Bonds
  4. Part 4: TIPS and TIPS Funds
  5. Part 5: Commodities
Part 3: Series I-Bonds

Series I Bonds (or iBonds) are a low-risk, liquid savings product. They are 100% backed by the US government and its ability to tax and print money. While you own them, they earn interest and protect you from inflation. Unlike Treasuries that pay interest at regular intervals, iBonds compound the interest similar to CDs. The rate you get for iBonds changes every six months based on the rate of inflation. You collect the interest and pay the taxes on the gains when you cash them in so they are a great way to defer taxable income.

Earnings rates for I bonds are set each May 1 and November 1. Interest accrues monthly and compounds semiannually. Bonds held less than five years are subject to a three-month interest penalty. I Bonds have an interest-bearing life of 30 years. When the inflation rate is less than zero, a bond's earnings rate is less than its fixed rate (but the earnings rate is never less than zero)

The current I Bond Earnings Rate is 3.36%

The earnings rate for Series I Savings Bonds is a combination of a fixed rate, which applies for the life of the bond, and the semiannual inflation rate. The 3.36% earnings rate for I bonds bought from November 2009 through April 2010 will apply for their first six months after issue. The earnings rate combines a 0.30% fixed rate of return with the 3.06% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U). The fixed rate applies for the 30-year life of I bonds purchased during this six-month period. The CPI-U increased from 212.709 to 215.969 from March 2009 through September 2009, a six-month increase of 1.53%.

I Bond Composite rate = [Fixed rate + (2 x Inflation rate) + (Fixed rate x Inflation rate)]

Inflation Bond Facts:
  • I Bonds earn interest from the first day of their issue month.
  • You can redeem them at any time after a twelve-month minimum holding period
  • They are an accrual-type security
  • They increase in value monthly and the interest is paid when you redeem the bond
  • I Bonds are sold at face value; i.e., you pay $50 for a $50 I Bond
  • I Bonds grow in value with inflation-indexed earnings for up to 30 years
  • If you redeem I Bonds before they’re five years old, you’ll forfeit the three most recent months’ interest; at or after 5-years, you won’t be penalized.
  • Annual rates compounded semiannually
  • Maximum purchase (per calendar year) is $10,000:
    $5,000 in TreasuryDirect and $5,000 in paper bonds
You may purchase I Bonds at www.TreasuryDirect.gov and at most local financial institutions.

Best Time to Buy I Bonds: Near the end of the month. Make sure you leave enough time for funds to clear.

Best Time to Sell I Bonds: At the start of the month since interest for the prior month is computed on the first of each month. You don't earn interest for fractional months so sell only after the new interest shows up in your account, usually the first of the month.

Disclosure: I own TIPS, TIPS mutual funds and Series I-Bonds. I also own and cover them in my newsletters. See Kirk's Two Investment Letters for more information.

More about Series I Bonds
Next: Come back later to read the next article in the series "Five Investments for Higher Inflation:Part 4: TIPS and TIPS Funds "

Disclosure: I sold all my bonds and bond funds not indexed to inflation. Besides cash in many CDs and savings accounts, I own TIPS, TIPS mutual funds and Series I-Bonds. I also own and cover these investments in my newsletters. See Kirk's Two Investment Letters for more information.

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