I Saving Bonds
I-Bonds, the Overview
Currently, I-Bond is the best investment vehicle for the purpose of building Safety-Cushion Fund. The I-Bonds are issued at face value and have a variable yield based on inflation. The interest rate consists of two components:
- fixed rate which will remain constant over the life of the bond.
- variable rate which is reset every six months from the time the bond is purchased based on the current inflation rate.
New rates go into effect on May 1 and November 1 of every year. The fixed rate is determined by the Treasury Department. The variable component is based on the Consumer Price Index from a six month period ending one month prior to the reset time.
Practically, that's the only paper investment instrument that keeps with inflation and is available to almost everybody. The most important features of I-bonds are:
- The interest earned on I savings bonds is subject to federal income tax, which can be deferred until redemption or final maturity, whichever occurs first (cash method). A bondholder may choose accrual method instead and pay taxes on interest on regular basis. Switching between cash and accrual method is not easy. The cash method is the default.
- Interest rate is equal or higher than inflation rate.
- The composite earnings rate of a bond changes every six months after the issue date.
- Minimum price of a single I-bond is just $50 for paper, and $25 for electronic bond.
- I bonds are issued to individuals only with a limit of $5,000 per person per year (per Social Security number).
- A person may purchase the limit of both paper and electronic bonds for a total of $10,000 per year (see: Purchase Limitations.
- Redeeming the I-Bonds before five years will incur a penalty of three months of interest.
- Minimum holding period is 12 months.
- I-Bonds mature in 30 years.
- Paper I-Bonds may be redeemed at any local bank or credit union branch.
- I-Bonds are sold at face value.
- I-Bonds are much safer than any money market fund.
More about I Bonds here: I Savings Bonds In Depth.
Why not corporate bonds?
Many corporate bonds pay much more than that meager 5.64% (Nov 1, 2008 - May 1, 2009). The corporate bonds are unsuitable for building the Safety-Cushion Fund for the following reasons:
- corporates are issued in $1000 denominations, and usually sold in amounts of 5 or more.
- the interest is taxed in the same year that it's paid.
- the best corporate bonds are not available to the public - look for corporate bonds at your broker's website, the only corporates available are of those failing banks and some other distressed companies amazingly still with highest ratings from Moody's.
- comission fees are too costly (about $10 per trade = $20 round-trip).
- if proper diversification requires at least 20 positions, minimum amount 5 bonds per position, face value $1000, then one needs 20x5x$1000=$100,000 to build a properly diversified bond portfolio. Definitely not for everyone.
- mutual funds investing in corporate bonds eat interest earnigns with their fees. Practicaly, you take the risk, they take the reward. What is left is taken away by inflation and taxes.
Off course there are corporate bonds of the good and stable companies available too. But the asking price is so high, that the effective yield is usually below inflation rate.
Buying I-Bonds
The I-Bonds can be bought online directly from the United States Department of the Treasury. The link: www.TreasuryDirect.gov. Click on the link and go to the Individual section. The registration process is very quick. Requirements: SSN, bank account number, name, DOB, etc. About 3-5 business days after the registration, the small card with security codes will arrive by mail. Log in, use the codes, and you can buy your first I-Bond. Check the User Guide for more details about buying I-Bonds and managing your account.
Cash vs Accrual Method
The purpose of the Safety-Cushion Fund is to use the savings to pay living expenses in times of hardship. Usually that means loss of job and loss of earned income. If one redeems the I-Bonds in a year with small or no income, then the effective and the marginal tax rates in such year will be very close to zero. No income tax paid on interest from I-Bonds.
A marginal tax rate is the tax rate that applies to the last dollar of the investor's taxable income. In other words, all the extra income is being taxed at this rate.
Some people may even never have to use their Safety-Cushion Fund throughout their entire life. In such case, the bonds will compound the interest until maturity date. When the bonds mature after 30 years, most people will enjoy their retirement, and due to no earned income will have very low marginal tax rate. Thus, only minimal income tax will be paid on interest from I-Bonds. And lets not forget about the power of compounding.
Example: The $5,000 invested in I-Bonds for 30 years will compound at a rate of 5% a year. In both cases an investor's marginal tax rate is 25%. In cash method the federal income tax is paid only once at maturity. In accrual method the tax is paid every year. The outcome:
| ENDING BALANCE | GAIN | AFTER-TAX GAIN | |
| Cash method: | $21,609.71 | $16,609.71 | $12,457.28 |
| Accrual method: | $15,087.36 | $10,087,36 | $10,087.36 |
The difference: $2,369.93.
Fixed-rate hunting
Hunting for the highest fixed rate may be quite rewarding. The table below shows I-Bonds interest rates.
| DATE | FIXED RATES | INFLATION RATES | COMPOSITE RATES |
| 1-Sep-98 | 3.40% | 0.62% | 4.66% |
| 1-Nov-98 | 3.30% | 0.86% | 5.05% |
| 1-May-99 | 3.30% | 0.86% | 5.05% |
| 1-Nov-99 | 3.40% | 1.76% | 6.98% |
| 1-May-00 | 3.60% | 1.91% | 7.49% |
| 1-Nov-00 | 3.40% | 1.52% | 6.49% |
| 1-May-01 | 3.00% | 1.44% | 5.92% |
| 1-Nov-01 | 2.00% | 1.19% | 4.40% |
| 1-May-02 | 2.00% | 0.28% | 2.57% |
| 1-Nov-02 | 1.60% | 1.23% | 4.08% |
| 1-May-03 | 1.10% | 1.77% | 4.66% |
| 1-Nov-03 | 1.10% | 0.54% | 2.19% |
| 1-May-04 | 1.00% | 1.19% | 3.39% |
| 1-Nov-04 | 1.00% | 1.33% | 3.67% |
| 1-May-05 | 1.20% | 1.79% | 4.80% |
| 1-Nov-05 | 1.00% | 2.85% | 6.73% |
| 1-May-06 | 1.40% | 0.50% | 2.41% |
| 1-Nov-06 | 1.40% | 1.55% | 4.52% |
| 1-May-07 | 1.30% | 1.21% | 3.74% |
| 1-Nov-07 | 1.20% | 1.53% | 4.28% |
| 1-May-08 | 0.00% | 2.42% | 4.84% |
| 1-Nov-08 | 0.70% | 2.46% | 5.64% |
| 1-May-09 | 0.10% | -2.78% | 0% |
The highest fixed rate was 3.60% in 2000 (May 1 - Nov 1). The fixed rate stays the same thougout the life of a bond. The composite interest rate, which is the actual interest rate the bond is earning, is calculated according to the following formula:
Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
An I Bond's composite earnings rate changes every six months after its issue date. For example, the earnings rate for an I bond issued in June 2000 changes every March and September.
The table below shows how the composite rate changed over time for bonds bought between May and November 2000:
| DATE | FIXED RATES | INFLATION RATES | EARNINGS RATE |
| 1-May-00 | 3.60% | 1.91% | 7.49% |
| 1-Nov-00 | 3.40% | 1.52% | 6.69% |
| 1-May-01 | 3.00% | 1.44% | 6.53% |
| 1-Nov-01 | 2.00% | 1.19% | 6.02% |
| 1-May-02 | 2.00% | 0.28% | 4.17% |
| 1-Nov-02 | 1.60% | 1.23% | 6.10% |
| 1-May-03 | 1.10% | 1.77% | 7.20% |
| 1-Nov-03 | 1.10% | 0.54% | 4.70% |
| 1-May-04 | 1.00% | 1.19% | 6.02% |
| 1-Nov-04 | 1.00% | 1.33% | 6.31% |
| 1-May-05 | 1.20% | 1.79% | 7.24% |
| 1-Nov-05 | 1.00% | 2.85% | 9.40% |
| 1-May-06 | 1.40% | 0.50% | 4.62% |
| 1-Nov-06 | 1.40% | 1.55% | 6.76% |
| 1-May-07 | 1.30% | 1.21% | 6.06% |
| 1-Nov-07 | 1.20% | 1.53% | 6.72% |
| 1-May-08 | 0.00% | 2.42% | 8.53% |
| 1-Nov-08 | 0.70% | 2.46% | 8.61% |
| 1-May-09 | 0.10% | -2.78% | 0% |
As can be seen in the table above, an I-Bond bought between May and November of the 2000, was yielding 9.40% between November 2005 and May 2006. That's quite a good yield considering safety of this investment vehicle.
Conclusion: even investors who have fully funded their Safety-Cushion Fund, should periodically check the fixed rate to lock a better yield.
Some more practical tips
While building the Safety-Cushion fund out of I-Bonds, an investor doesn't have to play with building a ladder. It's because when redeeming the I-bonds during the first 5-year holding period, the penalty is equal to 3-month interest. And after that period, it won't matter when the bond was purchased.
An investor should invest in CDs only when the CD interest rate multiplied by (1 - marginal tax rate)is higher than historical inflation rate of 3.5%.
Update (May 5, 2009): I-Bonds are not a good investment right now. Money are gaining purchasing power for the first time since 1955. The fixed rate has been lowered to 0.10% making I-Bonds a very unattractive investment vehicle.