Is It True That I Bonds Currently Pay No Interest?

Q: I have invested in I Bonds for the last 5 years. Can you tell me what interest rate they are now paying? I’ve heard there is no interest now being given on these bonds. -- MR

 

A: You've heard right. I Bonds’ current interest rate is zero. But don't panic and sell them! This is strictly a temporary phenomenon.

It's true that for the first six months after they're issued, I Bonds purchased between May 1 and October 31 2009 will pay zero interest. And every I Bond out there, regardless of when it was purchased, will earn zero interest for one six-month period.

But that isn't as dire as it sounds. In fact, the bonds are working as they're supposed to.  Even at the current zero interest rate, they’re outperforming inflation.

Here’s what you need to know:

I Bonds are issued by the U.S. Treasury. Unlike traditional bonds, which pay a fixed interest rate, I Bonds pay interest that adjusts to changes in the inflation rate.

The I Bond interest rate is based on two components:

The first component is a fixed rate, which is set for new I Bonds every May and November. This rate remains the same for the 30-year life of each bond. For bonds issued between May 1 and October 31 this year, the fixed rate component is 0.10%.

The second component is an inflation rate, which changes every six months along with the Consumer Price Index.

What you're seeing reflected in the I Bond's current zero interest rate is the fact that inflation was negative from September 2008 through February 2009.

In fact, for that six month period, the annualized inflation rate as measured by the CPI was minus 5.56%.

On November 1, the I Bond interest rate will be adjusted to reflect the CPI from March 2009 through September 2009.

Based on the data so far, inflation for that six month period is likely to be a positive number, says Daniel J. Pederson, who is a former supervisor of the Federal Reserve Bank's Savings Bond Division, and  the author of `Savings Bonds - When to Hold, When to Fold, and Everything in-Between'.  (This is a wonderfully comprehensive and easy-to-understand book that every savings bond investor should own.)

I Bond interest is subject to some dramatic short-term fluctuations because it only reflects the change in the CPI over a six month period, says Pederson. (In the six-month period before this one, for example, the CPI inflation component was 4.94%. The result: people who own I Bonds with a 3% permanent fixed rate component earned 7.94% for six months.) But over time, these ups and downs level out.

Investors typically pay more attention to the inflation component of I Bond interest -- but the fixed rate is the more important number because that's your real yield after inflation.

In other words, over the long-term, the I Bonds that are issued from May through October this year will pay 0.10% above the rate of inflation.

That doesn't sound awfully exciting. If you're planning to buy I Bonds, it's sensible to wait until November; their interest rate's fixed component can't get much lower, and the inflation component will probably be higher. But don't feel bad if you've already bought I Bonds that will pay 0.10% over the long term. That may be more than you'd earn in a Certificate of Deposit.

Here's why:

I Bonds can't underperform inflation - but CDs can, and often do.

Also, unlike CD interest, I Bond interest is exempt from state and local taxes. It is subject to federal tax - but the federal tax can be deferred until the bonds are cashed or until they reach final maturity, whichever comes first.

I Bonds resemble CDs in locking up your money for a period of time. You must hold an I Bond for at least one year. And if you cash it within five years, you forfeit three months of interest.

P.S. If you're doing the basic math, you may wonder why the current I Bond interest rate isn't negative. After all, the fixed rate component on new I Bonds is only 0.10%. Even the highest fixed rate component in I Bond history -- 3.6% -- isn't enough to overcome the current minus 5.56% inflation rate component.

The answer is that your earnings rate on an I Bond can never be less than zero.

 

Comments

[Jim & Karen G]

Lynn,

We bought I bonds in November 2001 and the fixed component is 3%. The problem is the investment is so good I dont want to sell them. Thus, I can't get an income stream from them. I guess I will hold as a last resort fund.

J&K G