Re: I series bonds versus CD

Caroline wrote:
> 
> "mark" <[EMAIL PROTECTED]> wrote
> > the I series and EE series bonds are now paying around 2.19 and
> > 2.61% respectively.
> > the best for I series in the past has been around like 3.6% or so.
> >
> > but the bank CD (FDIC insured) are available for around 4%
> > (compounded) interest rate when bought for 5 years.
> >
> > so why not go for the fixed CD instead ? i am reading posts in this
> > newsgroup and I series seems to be rated very highly ? the fixed rate
> > CD are FDIC insured so the risk factor can be said to be equal to the
> > I series bonds ?
> 
> All good questions.
> 
> Re CDs:
> Bankrate.com states the current average for five-year CDs is around
> 3.5%. I'd be surprised to find many, if any, paying 4% tomorrow.

Bankrate lists Capital One, Bank of Internet, Advanta Bank, Countrywide
Bank, etc. all paying 4% tomorrow.  "Average" means some are higher,
some lower.
 
> The 5-year CD locks your money up for five years, unless one wants to
> pay a big penalty.

The penalty is often 6 months interest, double the penalty for a
withdrawal from an I bond in under five years.  Though with the CD, you
can get your money out (with penalty) in the first year; with the I
bond, you can't.
 
> All the CD interest is taxable by federal and state governments.

True.
 
> Re I-bonds:
> One may sell I-bonds anytime after a year from the purchase.
> 
> I-bond interest rates have exceeded 4% in the last two years. E.g. see
> http://www.publicdebt.ustreas.gov/com/comi0503.htm

But see http://www.publicdebt.ustreas.gov/sav/sbirate2.htm

An I bond's interest is determined by its fixed component and its
variable component.  Its fixed component is 1.10%.  Its variable
component over the past two years (4 semi-annual settings) has
fluctuated between 0.28% and 1.77% (per six months).  With the exception
of the 1.77%, all the rates for the past three years have been at 1.44%
or less.

So one way we could look at I bond rates over the past three years is by
taking the fixed rate (which you'd be stuck with), and adding in the
variable rates at various times.  With the exception of that one six
month period, the I bond rates over the past three years would have been
under (and usually way under) 4%:

The formula on the webpage, using 1.10% fixed rate and 1.44% variable
rate (the highest rate, except for one, in the past three years), gives:

  1.10% + 2 * 1.44% + 1.10% * 1.44% = 3.995% 

> But more importantly, I-bond interest
> rates are unlikely to go down, as interest rates are at rock bottom
> now. 

Unlike EE bonds, the interest rates for I bonds do not track market
interest rates (EE bond rates are set to be 90% of the 5 year Treasury
rates).  Rather, I bonds track inflation.  There is a real risk of
seeing interest rates rise faster than the inflation rate, leaving the I
bonds with relatively low rates.

> They'll stay flat for five years or rise.

But from a level 1.8% below that of CDs you can find tomorrow (4%), they
have a lot to rise to make up that difference. 

> I-bond interest is exempt from state and local income tax.

True.
 
> If you hold the I-bond for one day past five years, you will not pay
> a 3-month penalty on interest.

Same for a 5 year CD (you get a grace period of a few days, so you can
hold the CD for 5 years and a day without it renewing :-).

> I-bonds keep earning interest after five years.
> So if you find you don't need the money after five years, you can let
> it keep growing in the I-bond until a "rainy day" arises.

This is a clear advantage (assuming that interest rates have not risen
faster than the inflation rate, in which case you'd want to own some
other type of fixed income investment, such as a CD with the then higher
rate).  It also has the advantage of deferring taxes even longer, so
long as you continue to hold the I bond.

> The federal government offers a tax break on I-bond interest designated 
> for college tuition.

There are income limitations that one should check, however.
> 
> One may buy, hold, and redeem I-bonds online.

Same for CDs.

Here's my answer to the original question:  People raved about I bonds
because they were (then) offering 4.66% for the first six months you
held the bond.  Even with the drop in their rate to 2.19%, that winds up
averaging almost 3.5% over a year.

Add in the fact that you can purchase them by credit card (getting 1% or
so back with the right card), and you have a pretty good 1 year
investment.  If the inflation rate goes back up, you wind up with an I
bond rate going forward that is comparable to the 5 year CD you could
buy today.  If the inflation rate doesn't rise, then you can buy your
way out after a year (3 months penalty will be cheap, less than what you
made with the credit card purchase).

What has changed: the 4.66% has dropped to 2.19%; the ability to
purchase with credit cards vanishes December 30th.

Over the past couple of years, I've done both - 5 year CDs (over 5%),
and I bonds (4.66% for six months, 1.5% cash back on CC purchase).  But
personally, I wouldn't invest in I bonds for the next six months (I
don't want to lock in a 2.19% rate for six months; I can get about the
same at an internet bank: 2%, with greater liquidity).

> Overall:
> Which is better depends on your needs, as you probably figured.
> If one can tie up one's money for no more than about five years,
> then a mix is often the best "gamble," rolling the dice that I-bond
> interest rates will rise. Or throw in some high grade investment bonds,
> too.

You can also do reasonably well with 5 year munis, if you benefit from
the tax breaks.

> Or buy some 1-year CDs and "bet" that CD rates will rise next year.

You may do better with MM accounts, yielding 2%.  (The top 1 year CD
rate that bankrate.com shows is 2.14%.)

> Of course, if we're not talking about much money,
> this may be hand-wringing over pennies.
> 
> Or if there's more to this five-year plan, laddering might be 
> an option to consider.
> 
> Good luck.

-- 
Mark Freeland
[EMAIL PROTECTED]