U.S. Treasury "I Bond" interest rate now 2.41% through October 2006

Last Fall some people were jumping up and down touting how wonderful the U.S. Treaury "I Bond" was since the interest rate in November was a whopping 6.73%. Unfortunately, that nice rate was locked in for only six months and was reset for the six-month May through October 2006 period to 2.41%, which is not so great at all. Even worse, that 2.41% rate is for new purchases since May 1, 2006. The new I bonds have a higher fixed rate of 1.40%, which when added to the six-month inflation rate of 1.01% gives the 2.41% rate. People who bought I bonds in the November 1, 2005 through April 30, 2006 six-month period have a lower fixed rate of 1.0% (which does not change for the 30-year life of the I bond), which when added to the new inflation rate gives a new annual interest rate of 2.11%, which is even less attractive.

To add insult to injury, you cannot redeem your I bond at all in the first year and have to pay a three-month interest penalty if you redeem within the first two to five years.

I bonds are a great idea when we are heading into a protracted period of high inflation, but we are not doing so at this time.

Still, the return wouldn't be a complete disaster if you bought on November 1, 2005 and then sell on August 1, 2006. You would get 3.365% actual total return for the first six months and then forego the three months interest from May 1, 2006 as the penalty, giving you an annualized rate of 4.487% (6.73% divided by twelve months multiplied by six months divided by nine months multiplied by twelve months), which is a bit better than if you held T-bills for that same period. But going forward, continuing to hold that I bond will incrementally lower your return as each month ticks by. It might be better to shift it over to T-Bills. Whether you should sell or not depends on a lot of factors, not the least of which is your forecast for future inflation rate expectations.

The actual rate that you will earn depends on when you purchased the I bond. For example, according to the official U.S. Treasury I Bond Interest Rates table, people who bought I bonds between May 1, 2000 and October 31, 2000 will earn at a 4.62% rate since their fixed rate is locked in at 3.60% for 30 years.

The actual calculation for the "composite" interest rate is as follows:

Composite rate = [Fixed rate + (2 x Infl. rate) + (Fixed rate x Infl. rate)]

For current I Bond purchases, the Fixed rate is 1.40% and the Infl. rate is 0.5%:

Composite rate = [0.0140 + (2 x 0.0050) + (0.0140 x 0.005)]
Composite rate = 0.0140 + 0.01 + .00070
Composite rate = 0.0140 + 0.0107
Composite rate = 0.02407
Composite rate = 0.0241
Composite rate = 2.41%

The inflation rate was calculated by subtracting the Consumer Price Index for all Urban Consumers (CPI-U) for September 2005 from March 2006. The index in September 2005 was 198.8 (1982-84=100) and 199.8 in March, a difference of 1.0 which is 0.503% of the September index.

The essence of investing in the Treasury I Bond is a bet on sistained high inflation. If that's want you believe is likely, I Bonds may be worth considering, but if you feel that inflation is going to be fairly subdued, I Bonds won't have much to offer you. It's your decision, based on your outlook.

-- Jack Krupansky