Wednesday, February 14, 2007

iBonds

I have been doing a series of posts on investing. Recently I covered the basics of bonds and the fact that leveraged buyouts (and resulting decreases in credit quality) are forcing bond issuers like corporations to put in protection for bond purchasers in case of a "change in control".

This post focuses on a specific type of bond that can be purchased through the US Government. Like all US Federal Government debt, this bond has essentially zero chance of default, defined as no credit risk.

About iBonds and Calculating the Interest Rate:

iBonds are issued by the US Government. iBonds can be purchased at www.treasurydirect.gov after you set up an account and provide appropriate information, at zero charge. Note that fees on buying and selling debt can add up; for some seldom traded or illiquid issues it can cost a few percentage points on face value to buy or sell (this is a significant factor because debt doesn't pay much above the risk free rate and these expenses will take a long time to recoup). The iBonds are issued electronically and the money moves electronically which makes them very convenient, as well.

Unlike virtually all other types of bonds, the iBond interest or "coupon" rate is tied to the inflation rate as measured by the US Government. Virtually all other bond instruments either adjust their coupon rate according to how interest rates move (short term rates mainly determined by the Federal Reserve, long term rates a combination of short term rates and market sentiment) or the price adjusts (i.e. if you have a bond paying 6% interest and the market price moves to 5%, you could sell that bond for a gain in the market and it would be priced "above par"), depending on the type of bond.

The iBond has 2 components; a "fixed" interest rate that has varied between 1% (low) to 3.4% (high) and a semi-annual interest rate component tied to the rate of inflation. iBonds have a thirty year maturity.

The "fixed" interest rate component has had different base rates since the iBond program was started in 1998. The "fixed" component was 3.4% in 1998 and then dipped as low as 1.0% for bonds purchased between Nov 1, 2005 and April 30, 2006 (note... this is when I bought my batch of iBonds... as usual my market timing stinks). The current fixed rate component on iBonds is 1.4% for bonds purchased between November 1, 2006 and April 30, 2007.

The "variable" interest rate component is determined by the inflation rate, divided by 2 (the semi-annual inflation rate). The current semi-annual inflation rate is 1.55%, or 3.1% for the year. Thus iBonds purchased between November1, 2006 and April 30, 2007 pay about 4.52% (it is slightly higher than 1.4% + (1.55% * 2) because of compounding interest).

Note that if you buy different issues (i.e. 30k / year) of iBonds, your fixed rate may vary by year, but the "variable" component will be the same for each issue over every six month period. I realize this is confusing (it confused me, for what that is worth) and here is a link to the government site where they try to explain it.

iBond Limits and Redemptions:

An individual can purchase up to $30,000 / year in iBonds. If you are married and want to go into details 2 individuals can purchase $60,000 / year in iBonds under 2 SSN's.

UPDATE - THE LIMITS HAVE BEEN REDUCED TO $5000 / YEAR AS OF 1/1/08.

You can't sell back your iBonds in the first year after purchase (unless there is a natural disaster or some other unique circumstance in your area); thus they are not "cash and cash equivalents" per my prior post.

If you sell back your iBond within 5 years of purchase, you lose one quarter of one years' interest. After 5 years you can redeem your iBond with no penalty.

iBonds and Taxes:

The advantage of iBonds is that you can defer Federal taxes on iBonds until they are redeemed, and they are immune from state and local taxes. Deferring taxes in this manner is useful because the interest that would have been taxable grows at a compond rate for the life of the bonds. In some circumstances (using them for education), the interest isn't taxed at all when the bonds are redeemed (you should read about these at the government site, I am not an expert on the various criteria, but they seem pretty generous). Overall, iBonds receive very favorable tax treatment.

iBonds and Inflation:

iBonds provide protection against future inflation. If you own a bond with a fixed coupon at, say 6%, and inflation moves from 3% (current rate) to 5%, it will significantly erode the value of your bond (the price in the market will be lower if you want to sell it prior to maturity; you will receive your same coupon payments in the meantime). For iBonds, however, they automatically adjust to the inflation rate, and thus they provide a "hedge" against changes in inflation. For this reason it may be good to have them in your portfolio, because they are not correlated with your other investments (this is a good thing in "portfolio theory" terms).

Note that inflation as computed by the Treasury may not match actual inflation; they measure a basket of goods and don't count services like college costs nor do they count real estate (an asset). Thus YOUR rate of inflation could be much higher (or potentially lower) than the rate quoted for your iBond.

Summary:

You may want to look into iBonds, especially if you are in a high tax bracket or the AMT. iBonds have very favorable tax treatment, more so if your state has a high tax rate. iBonds are also attractive if you are saving for college for yourself or your children; the interest may be non-taxable if used for certain purposes.

iBonds don't come with any expenses and are easy to buy and sell. You don't have to deal with a broker, you can just do it all online at the Federal government site.

Right now, iBonds are paying less than a money market account, which diminishes their attractiveness. The "fixed" component of 1.4% is also pretty low, although better than the 1.0% when I bought it...

The 1 year "lock up" and 5 year "interest penalty" of one quarter means that you shouldn't use this for your emergency fund. They might be a good component of a balanced investment program, especially if inflation rises which will erode your other bond and fixed rate investments.

2 comments:

Anonymous said...

You have this backward. The fixed (1.4%) stays fixed.

your fixed rate may vary by year, but the "variable" component will be the same for each issue

Anonymous said...

Today is Feb 9 2008
I bought I Bonds in 2001 and 2003. Because of the formulas, the current return on the 2001 bond is 8.4% and on the 2003 bond 6.3%.
If we have deflation, my "low" "fixed" guarantee is 3.4% and 2.3%... if we have 10% inflation, I'll receive about 20%, on the higher yield bond. if I read the formula correctly.
'Course if the government is truly broke... I'm in the barrel with everyone else. Until 2008, the per person limit was $30,000 year... now it's down to $5,000.