I Bonds

[Anne Brennan]

I just found this group. I would like to know how the government sets
its interest on the I Bonds. I understand there is a basic rate
that doesn't change in May and Nov. There is also the inflation rate
which does change in May and Nov.. I understand howthe inflation rate
is determined, but I would like to know what determines the basic rate
change.

In the late 90s I purchased I Bonds, the basic rate was 3% and inflation
was 3%, giving me a total of 6%. Those bonds have paid quite well
since I purchased them especially considering how low interest rates
have been the last 5 years or so. I read the basic rate is now 1%.
What factors made the government change that rate from 3% to 1%? I
hope my question is worded clearly. Thanks for any help. Anne

 

[Andy]

In the late 90s I purchased I Bonds, the basic rate was 3% and inflation
was 3%, giving me a total of 6%. Those bonds have paid quite well
since I purchased them especially considering how low interest rates
have been the last 5 years or so. I read the basic rate is now 1%.
What factors made the government change that rate from 3% to 1%? I
hope my question is worded clearly. Thanks for any help. Anne

I assume its supply and demand; the US Treasury sets the base rate as
low as they think they can get away with and still sell enough bonds.
Since interest rates have been quite low the past few years they have
been able to lower the base rate to 1% and still sell bonds. When long
term interest rates rise again I assume they will raise the base rate
to remain competitive.

Andy

 

[Rich Carreiro]

I just found this group. I would like to know how the government sets
its interest on the I Bonds. I understand there is a basic rate
that doesn't change in May and Nov. There is also the inflation rate
which does change in May and Nov.. I understand howthe inflation rate
is determined, but I would like to know what determines the basic rate
change.

Are you talking about I-Bonds (which are savings bonds) or TIPS
(which are tradeable securities)?

For TIPS, the govt sets the basic rate such that the total yield of
the bonds is about what Treasuries of similar term are currently
trading for in the market. The idea is for the bonds to sell right
around face value.

For I-Bonds I would imagine a similar process is used (because if
the rate is set too low people won't buy them), but since there's
no market feedback, and because people often buy savings bonds for
not terribly rational reasons (though of course many many people
buy them for perfectly rational reasons), I bet the govt can get
away with using slightly lower base rates than they do with TIPS.

 

[BreadWithSpam]

I just found this group. I would like to know how the government sets
its interest on the I Bonds. I understand there is a basic rate
that doesn't change in May and Nov. There is also the inflation rate
which does change in May and Nov.. I understand howthe inflation rate
is determined, but I would like to know what determines the basic rate
change.

There is no direct market force or participation in the determination.
The Treasury simply sets it. Take it or leave it. Clearly they
take into account prevailing "real" rates, but it's simply set
by the Treasury.

Almost all of the rest of the Treasury securities (bills, notes,
bonds, even TIPS) have their yields set by the market through
auctions. Savings bonds - series I and EE ("iBonds" as we
seem to call them in most discussions) have no market.

In the late 90s I purchased I Bonds, the basic rate was 3% and inflation
was 3%, giving me a total of 6%. Those bonds have paid quite well

Those were a great deal. A 3%, tax-deferred (free from State tax)
guaranteed *real* return - with no real interest rate or
inflation risk is pretty solid. Of course, at the time, folks
were busy believing that they could get 20% returns in the
stock market...

Nevertheless, after taxes (which are real, even though deferred),
the overall return won't be anywhere near 3% above inflation,
but they are pretty likely to be positive.

since I purchased them especially considering how low interest rates
have been the last 5 years or so. I read the basic rate is now 1%.

1% isn't so great. After taxes and all, even deferred as they
are, you probably won't quite match inflation with them.

What factors made the government change that rate from 3% to 1%? I

The Treasury simply sets it. Relative to other treasury securities,
a 3% real rate was actually a pretty rich yield. After taking
inflation into account, mid-range treasry securities aren't
paying much more than that. The 5-year treasury note is
yielding about 4.5% right now. The CPI-U change for the 12
months ending Dec 05 was 3.4%.

On Nov 1, '99, the 5-year was yielding 5.85% and the CPI-U
for the 12 months ending Dec '99 was 2.7 -- and the fixed
rate offered on iBonds in Nov '99 was 3.4% - even for those
times, fairly rich, given a "real" rate on the 5-year of
about 3.15% (and that "real" rate was more risky, since
inflation could have heated up during those five years,
though it really didn't do so very much - it was up and
down as high as 3.4% and as low as 1.6%).

 

[Tad Borek]

In the late 90s I purchased I Bonds, the basic rate was 3% and inflation
was 3%, giving me a total of 6%. Those bonds have paid quite well
since I purchased them especially considering how low interest rates
have been the last 5 years or so. I read the basic rate is now 1%.
What factors made the government change that rate from 3% to 1%? I
hope my question is worded clearly. Thanks for any help. Anne

Anne,
The I-bonds you have are very valuable because that base rate is fixed
for the entire life of the I-Bond (30 years). As you saw, if you walk in
today and buy 2006 I-bonds you will receive interest of about 1% plus
the inflation adjustment, which is reset every six months based on the
change in the consumer price index.

Your bonds pay 3% plus the SAME inflation adjustment, so you're earning
an extra 2% (tax-deferred) per year more than someone buying an
otherwise-identical I-bond today.

Why was the early rate so much higher? I-bonds were brand new at the
time and perhaps they wanted to draw some interest (!) in them by
providing a better rate. And interest rates in general were a lot
different at the time so it's arguable that the US Treasury needed to
set a generous base rate so people would buy them.

I recommend that people who bought those early-series I-bonds keep them
as long as possible. It's very difficult to find a tax-deferred
investment that will yield 3% more than the basic inflation rate -
arguably, there isn't one with as much security as your I-bond. And an
extra 2% is, believe it or not, an enormous difference. Let's say you
end up holding for 20 years and earning 6% annually instead of 4%. You'd
end up with $3207, instead of $2191, for every $1000 invested at time of
purchase. After 30 years the numbers would be $5743 vs. $3243.

-Tad

 

[anoop]

(e-mail address removed) (Anne Brennan) writes:

1% isn't so great. After taxes and all, even deferred as they
are, you probably won't quite match inflation with them.

But one would probably do a lot worse with any other zero-risk
fixed income investment -- you would be guaranteed to fall
behind inflation.

Anoop

 

[BreadWithSpam]

But one would probably do a lot worse with any other zero-risk
fixed income investment -- you would be guaranteed to fall
behind inflation.

I take back what I said. It's possible to end up doing
worse than inflation, but it requires absurdly high
inflation rates and eventually, even at 1% fixed rates,
the i-bond always wins. At 1% fixed, 15% taxes and,
get this, a 20% inflation rate, it's breakeven at about
20 years - before that, you're falling behind against
inflation.

Assuming $1000:
At 3% inflation, 1% fixed, 15% taxes, the iBond is
always ahead. After 30 years, the i-bond is ahead
with an after-tax value of $2906 versus $2427.

And, for our OP who may be wondering how huge a
difference of 3% v. 1% fixed rate is:
At 3% inflation, 3% fixed, 15% taxes, $1000:
after-tax value = $5032 versus the same $2427.

(quick and dirty estimate based on annual compounding, and
i-bond rate == $fixed + $inflation -- which is *not*
really how it's done, but it's close enough for this
example.)

 

[Anne Brennan]

Thanks to each of you who answered my question. I have been trying to
find that information for some time. I guess I did myself a favor
buying those bonds during late 90s. I dont think I will buy more I
bonds until the government increases the basic rate. After all taxes
will come due when the bonds are cashed and that needs to be considered.
Anne

 

[Andy]

I dont think I will buy more I
bonds until the government increases the basic rate. After all taxes
will come due when the bonds are cashed and that needs to be considered.

It may be a long time until the government increases the basic rate. As
far as I can tell economists do not have a good handle on why interest
rates are so low these days and so its hard to come up with an evidence
based theory for why they would rise again in the near term. When
making investment decisions I think one should assume that there is a
respectable chance that long term interest rates will stay low for an
extended period, i.e. I wouldn't postpone actions on the belief that a
substantial rise in interest rates is just around the corner.

Andy

 

[Bobby Sawhney]

Andy,

I think they just might have to increase the basic fixed rate soon for the
I-Bonds. It will be very interesting to see what happens to the fixed rate
of the May 2006 I-Bonds.

Given, that the CPI-U numbers had jumped up considerably in Sep 2005 (moving
from 196.4 to 198.8) and was actually lower than that in Feb 2006 (198.7),
my guess is that the CPI-U number in Mar 2006 will not be that much higher
than that of Feb 2006.
Lets say it jumps to 201 from 198.7 (which is a pretty high jump, the actual
increase might be lower than this). This would give a Semiannual inflation
rate of 1.1% yielding only 3.21% rate for the May 2006 I-Bonds.

So, if the treasury does not increase the 1% Fixed rate component of the
I-Bond, then it will be yielding much lower than other available investments
and might not generate enough buying interest.

Thoughts ?

-bobby