Publication: Investor's Notebook
THE MANY BENEFITS OF I SAVINGS BONDS | |
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Investor's Insight - Wednesday, January 25, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
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THE MANY BENEFITS OF I SAVINGS BONDS
by Scott Burns
Reader mail tells me that I Savings Bonds are one of the
most misunderstood good deals available to the investing
public. They offer a competitive return, can be held for
up to 30 years, and can be redeemed in relatively small
amounts at no cost. While they are being held, the inte-
rest they earn is accumulated tax-deferred.
Unlike mutual funds that invest in bonds, the value of
I Savings Bonds does not fluctuate. It only goes up.
Unlike most tax-deferred annuities, the penalties for
early redemption are not severe.
Unlike brokered CDs, the value of the investment does not
fluctuate with interest rates.
So let's start at the beginning and go through the basic
questions:
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What are I Savings Bonds? Unlike EE Savings Bonds, which
earn and accumulate tax-deferred interest at a rate pegged
to the rate on five-year Treasury obligations, I Savings
Bonds offer an inflation-protected rate of return based on
the Consumer Price Index and a premium over the inflation
rate. Like EE Savings Bonds, the interest earned is accum-
ulated tax-deferred.
How is the yield on I Savings Bonds determined? Every six
months the basic interest rate may change. The basic inte-
rest rate is a premium that is added to the rate of infla-
tion. Bonds purchased in the current period (November to
April), are earning at a 6.73 percent annualized interest
rate based on a 1 percent premium and a 5.70 percent in-
flation rate.
Bonds purchased in other periods will be earning at diffe-
rent rates because there were different basic interest
rates in other periods. These rates varied from a high of
3.60 percent for bonds purchased in the May to October
2000 period to a low of 1 percent for bonds purchased in
the November 2005 to April 2006 period. Since the rate of
inflation is added to each basic interest rate, ALL the I
Savings Bonds issued in earlier periods are currently
earning more than 6.73 percent. Bonds purchased in the May
to October 2000 period, for instance, are currently earn-
ing a whopping 9.40 percent.
Why is the basic interest rate so much lower today than it
was when the bonds were introduced? Think of it as market-
ing. The bonds were new and unfamiliar when they were in-
troduced in 1998. Today, people understand that the basic
rate is a premium over the inflation rate. The 1 percent
basic rate bonds available today are yielding 6.73 percent,
well over yields on bank CDs, tradable Treasury securities,
and mutual funds that invest in government securities.
Will the current yield decline? It all depends on the in-
flation rate. If inflation declines, the composite interest
rate (basic rate plus inflation rate) will decline. The
real return over the rate of inflation, however, will be
fixed at whatever the basic interest rate is when you buy
the bonds. If you are concerned about future inflation,
these bonds are likely to give you more protection than
conventional bonds.
Is a 1 percent premium over inflation a good rate? Accord-
ing to Ibbotson Associates, intermediate and long-term
government bonds earned a premium of 2.4 percent a year
over the annual inflation rate between 1926 and 2004. U.S.
Treasury bills earned a premium over inflation of only 0.7
percent over the same period.
Investors, however, could experience long periods when in-
flation exceeded what they were earning on their convent-
ional bonds. I Savings Bonds will always earn a premium
over inflation. In addition, the interest is tax-deferred.
As a consequence, I believe they are superior to Treasury
bills and competitive with conventional bonds. They are
particularly superior to most mutual funds and variable
annuities that invest in government bonds because mutual
fund and variable annuity expenses reduce their advantage.
The average intermediate-term government bond fund, for
instance, has an expense ratio of 1.09 percent. This would
reduce the 2.4 percent premium over inflation to 1.31 per-
cent -- and the yield isn't tax-deferred. The average in-
termediate bond sub-account in a variable annuity has a
total expense burden of 1.90 percent, reducing the 2.4 per-
cent historic premium over inflation to 0.5 percent.
When you do the math against competing vehicles, I Savings
Bonds look very attractive.
Do I Savings Bonds have any other advantages? They are
particularly useful for retirement planning and taxes.
Since they can be redeemed at their accumulated value at
any time after five years without penalty, they offer risk-
free access to sums of money in very flexible amounts.
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In addition, your tax liability will be on only the accu-
mulated interest portion of the redeemed amount. A $100 I
Savings Bond purchased in November 2000, for instance,
will be redeemable for $139.88 this April. A retiree can
access the full amount but will need to pay income taxes
on only $39.88 in interest.
In comparison, mutual fund returns are currently taxable.
Variable annuity withdrawals are 100 percent taxable in-
come until the accumulated income is exhausted.
Where can I buy I Savings Bonds? The surest way is to use
the Web. Enter your ZIP code in a site listed below, and
it will give you the phone number of the nearest Federal
Reserve Bank. You can also set up an account online. It
is also possible to buy them through a regular bank, but
many readers who have tried say they are not available
through that channel.
ON THE WEB
Enter your ZIP code and find the Federal Reserve Bank for
help and transactions: www.publicdebt.treas.gov/sav/savfrb
Composite earnings rates for I Savings Bonds with diffe-
rent issue dates: www.publicdebt.treas.gov/sav/sber0506
Rate on I Savings Bonds purchased in this period:
www.publicdebt.treas.gov/com/comi1105
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2005 UNIVERSAL PRESS SYNDICATE
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