By
msnbc.com contributor
updated 5/8/2008 11:24:44 AM ET 2008-05-08T15:24:44

Inflation-indexed savings bonds were meant to protect owners from the ravages of rising prices: No matter how high inflation went, I-Bond yields would always be higher.

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Not now. On May 1 the government pulled the rug out by announcing that the newest batch of I-Bonds — those sold from May 1 through October — would not contain that inflation-protection feature. Fortunately, the decision doesn’t affect bonds sold before May 1.

Investors’ first impulse might be to spurn the new bonds, waiting until Nov. 1, when terms are announced for ones sold in the following six months. But it’s not that easy: this current batch, despite the lack of inflation protection, carries a generous 4.84 percent annual yield for the first six months.

What’s it all mean?

It boils down to this: the current issue of I-Bonds could be a good short-term holding. Never mind that you’ve been told for years that I-Bonds are for long-term investors only.

Before explaining that, let me hit the basics. The I-Bond’s yield, or interest payment, comes in two parts. First is a variable rate that the government adjusts every six months during the bond’s 30-year life. It is designed to match the inflation rate for the previous six months. If inflation ran at an annual rate of 3 percent, the variable rate would be set at 3 percent. If inflation later rises to 5 percent, the variable rate would shift to 5 percent.

The new variable rate is announced every May 1 and Nov. 1. It takes effect on the six- or 12-month anniversary of the bond purchase. So, if you buy a bond on July 1, on the following Jan. 1 you’ll start earning the variable rate set on Nov. 1. Changes in the variable rate apply to all I-Bonds in existence — those issued recently as well as those sold years ago.

It couldn’t be simpler, right?

The second part of the yield is called the fixed rate. Again, this is established every May 1 and Nov. 1, but the new fixed rate applies only to the bonds sold over the following six months. For those bonds, the fixed rate is permanent. If it starts at 1 percent, it stays at 1 percent for 30 years. If a previous batch of bonds had a fixed rate of 2 percent, they stay at 2 percent.

It is the fixed rate that ensures the bond’s yield always beats inflation — by 1 percent, 2 percent, whatever the fixed rate is for bonds sold in a given May through October period.

The bonds sold from last Nov. 1 through the end of April carried a 3.06 percent variable rate and a 1.2 percent fixed rate, for a total, rounded, of 4.28 percent. On May 1, the variable rate was changed to 4.84 percent. So, with rounding, those I-Bonds are now earning 6.11 percent.

But the new batch of bonds pay just the 4.84 percent variable rate — the fixed rate is zero. Buy one of these bonds and you’ll always earn the inflation rate, but you’ll never get ahead of inflation.

The government uses a complicate formula to set the fixed rate, but it boils down to the fact that the feds don’t want to be more generous with savings bonds then they are with other government bonds, such as Treasuries. After all, the interest payments are funded by taxpayers. The 30-year Treasury bond, the most generous, currently pays just under 4.6 percent.

Without the inflation protection, I-Bonds aren’t suited to the classic long-term goals that have attracted people in the past, such as saving for retirement or grandchildren’s college educations.

But at 4.84 percent they could appeal to short-term investors who want to earn more than they can in other super-safe savings, such as federally insured bank certificates of deposit. Six-month CDs are paying around 2.75 percent, and five-year CDs just 3.5 percent.

Before plunging into I-Bonds, note that you cannot redeem one until you’ve owned it for at least 12 months. You would get the 4.84 percent annualized rate for six months, but for the following six months you’ll get the rate that will be set Nov. 1.

Also, if you redeem an I-Bond within five years of your purchase date, there is a penalty equal to the final three months’ interest earnings.

Imagine you bought an I-Bond today and the rate stayed the same on Nov 1. With the three-month penalty, you’d pocket around 3.6 percent over 12 months. With a 12-month CD you’d probably get around 3 percent.

Remember though that interest earnings on savings bonds, though exempt from state and local tax, are generally subject to federal income tax — though investors below certain income limits can get exemptions if earnings are used for education expenses. For details look at IRS Publication 970.

You can get I-Bonds for as little as $25. But an individual can buy only $5,000 worth of I-Bonds in a calendar year, or $10,000 if you buy half in electronic form and half in paper form.

I-Bonds are no good for people who need steady income, because you don’t get the interest earnings until a bond is redeemed. Taxes are owed only after redemption.

Many banks and credit unions sell I-Bonds, and they can be purchased directly from the government. The Web site carries lots of information.

A final note: The savings bond Web site compares I-Bonds to another government bond called Treasury Inflation-Protected Securities, or TIPS. Explaining TIPS would take another column, but for now be warned that they’re very, very different from savings bonds. Their value fluctuates with market conditions, so it’s possible to lose money — lots of money. With savings bonds, your principal is safe.

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