I Savings Bonds used to be a great investment, especially during the stock market bubble of the late 1990s, when they were paying 3.6% interest, plus the inflation rate. And back then, you could buy $60,000 of them a year and … use a credit card to buy them! (Great way to rack up frequent flier miles.)
I Bonds haven’t been so attractive in recent years, they rarely get mentioned anymore. I Bonds typically pay a base interest rate that is lower than a Treasury Inflation Protected Security. They both get the inflation adjustment to principal, so that typically makes a TIPS a more attractive investment. (With I Bonds, the inflation adjustment is added to the base interest rate, which changes every six months.)
Nowadays, you can only buy $10,000 a year of I Bonds ($5,000 paper, $5,000 at Treasury Direct – per Social Security number – so a couple could buy $20,000 in one year). And of course that credit card deal was long ago phased out. Everyone’s conclusion: I Bonds just aren’t worth considering.
And that conclusion is wrong.
I Bonds currently have a base interest rate of 0.0%, plus the rate of inflation until you cash them out. The inflation ‘add-on’ interest rate is adjusted twice a year (May 1 and November 1). You need to hold them one year, and if you sell them before five years you face a three-month interest penalty.
Versus a 5-year TIPS? We just had a 5-year TIPS auction that went out at an effective interest rate of -0.18%, plus the inflation adjustment. So at this point, getting 0.0% with an I Bond is better than -0.18% for a TIPS, assuming you cash out after five years.
In addition, TIPS offer better protection against deflation, when compared to TIPS.
Current interest rate? Because of the odd way the Treasury adjusts the I Bond’s interest rate twice a year based on inflation, the I Bond is currently paying 4.60% through October 31, 2011. (That rate will likely fall dramatically in October when inflation balances out. We’ve had a short-term run of gas and food inflation.)
People seeing a rate of 4.6% might lured back into I Bonds. That rate is misleading, but the fact is I Bonds are a better investment (and have some tax advantages, too) than TIPS for the first $5,000 you invest for the next five years.