Price rise good for I bond investors

PERSONAL FINANCE

April 29, 2008|By EILEEN AMBROSE

Gas and food prices are rising. Wallets are hurting. But it's not all bad news. Higher prices mean the interest rate on U.S. savings bonds tied to inflation will be going up, too.

The interest rate on government I bonds adjusts every six months. The next adjustment will occur Thursday, and any I bonds purchased after that will probably carry an annualized rate above 5 percent, up from 4.28 percent now.

But don't wait until Thursday to buy I bonds. Buy now, and six months from now you'll be earning more than 6 percent. I'll explain shortly.

I bonds have the same features other savings bonds do. They are backed by the U.S. government.

You don't have to pay state or local taxes on any interest earned. You don't owe federal taxes until you redeem the bonds. The difference with an I bond is that its interest-rate formula is designed to protect you against inflation.

Here's how it works:

An I bond has two interest-rate components.

The first is based on the Consumer Price Index, and it can change every six months. The other rate is fixed over the bond's life. The two are combined and slightly adjusted upward, and that's the rate you earn for half a year. Six months later, you earn whatever the new inflation-based rate is plus the fixed rate.

Today's I bond is a combination of a 3.06 percent inflation-based rate and a 1.2 percent fixed rate.

Based on March's inflation report, we know that inflation-based rate on I bonds as of Thursday will be 4.83 percent. Only after Hurricane Katrina in 2005 has the inflation-based rate been higher.

We won't know until Thursday, though, whether the fixed rate on newly issued bonds will be changed. (Again, if you already have an I bond, your fixed rate is set in stone.

But the government always has the option of changing the fixed rate each May and November on new bonds.)

Experts predict that the fixed rate for new bonds will go down. If they're right, that's why you need to buy I bonds before Thursday. Otherwise, you'll be locking yourself into a lower fixed rate for years.

And over the long haul, the fixed rate is critical.

"It's really the key when comparing one I bond to another. What you want is an I bond with the highest [fixed[ rate," says Tom Adams, author of Savings Bond Advisor.

How low can the fixed rate go Thursday?

The fixed rate on I bonds usually is about 1 percentage point below the rate on 10-year Treasury Inflation Protected Securities, Adams says. The rate on 10-year TIPS last week was 1.5 percent. Given that, the government could lower the fixed rate to 0.50 percent, he says. Adams adds, though, that the fixed rate has never dropped below 1 percent, and that might be the new fixed rate.

Buy an I bond before Thursday and you'll earn the current rate of 4.28 percent for half a year. For the next six months, you'll earn 6.06 percent. That's the new 4.83 percent inflation component plus the 1.2 percent fixed rate, adjusted slightly upward.

Not bad, especially when you compare it with other conservative investments. The average rate on a five-year certificate of deposit last week was 3.35 percent, according to Bankrate.com.

You can buy I bonds from banks and credit unions, or online from the government at www.treasurydirect.gov. The minimum purchase is $50 for paper I bonds and $25 for the electronic form.

In January, the government reduced the maximum amount an individual can buy annually. It used to be $30,000 a year. It's now $5,000 in paper bonds plus $5,000 in electronic bonds, for a total of $10,000.

"It was to get the savings bond program back to its roots" as an investment for small savers, explains Stephen Meyerhardt, a spokesman with Treasury's Bureau of the Public Debt.

But Adams says he suspects that the government lowered the limit to appease banks that don't like to compete with the Treasury for business.

I bonds have other restrictions, too. You can't redeem an I bond in the first year. And you'll lose your latest three months' interest if you cash out before five years.

Even with those restrictions, I bonds make an attractive addition to portfolios.

eileen.ambrose@baltsun.com

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