Wednesday, July 28, 2010

Plusses and Minuses of I Savings Bonds, Part I

So far in this group of posts on savings bonds we have covered the now defunct Series E bonds, the basics of Series EE Bonds, the basics of Series I Bonds, how to buy and sell savings bonds and two posts comparing Series EE savings bonds with Certificates of Deposit (CDs) and Treasury bills and notes.

The return on Series I bonds consists of a real interest rate, which is set at the date the bond is issued, and an inflation component, which depends on inflation over the bond’s life. Because of this inflation component, the closest alternative investment is the Treasury Inflation Protection bond (TIP) issued by the Federal Government.

In this post I will avoid repeating much detail from earlier posts when the comparison of Series I bonds and TIPs is the same as for Series EE bonds and Treasuries.

How Inflation is Recognized in the Bond: Before we make comparisons between Series I bonds and TIPs, it is useful to understand the differences in how inflation is recognized under each. With Series I bonds your interest rate is reset every six months equal to the initial real rate plus an inflation adjustment based on recent historical inflation. The key point for this discussion is that if deflation occurs for a period of time, the interest rate cannot be lower than the real rate. Because you always minimally earn the real interest rate, the value of your Series I bond is monotonically increasing (i.e. it never decreases, although it may stay constant for a period of time if your real rate is 0%).

TIPs are also issued with a real rate of return. TIPs, however, operate through a different mechanism: the principal amount reflects accumulated inflation since the bond’s issue. To determine the current principal amount, multiply the original principal amount by the ratio of the current CPI to the CPI at issue. Interest is paid every six-months determined as the real rate of return multiplied by the adjusted principal.

If the economy only experiences inflation (no deflation), these two mechanisms will produce very similar results assuming they started with the same real interest rate. The main difference is that Series I interest compounds, whereas TIP interest is paid out (and must be reinvested to compound.)

Deflation: The interest rate on Series I bonds cannot be decreased below the real interest rate. The principal on TIPs can be reduced below the original issue when used to determine the interest paid. Upon maturity, if the adjusted principal remains below the original principal, the bond pays the original principal, so no principal is lost due to deflation. However, the interest paid for any six-month period can be less than the real rate multiplied by the original principal.

To illustrate, assume both the Series I bond and the TIP have a real rate of return of 2%. Prior to their issue inflation has been steady at 0%. After six months the measured inflation has increased 5%. During the next six months the measured inflation is -10% (severe deflation). During the third six months inflation again roars ahead at +5%. These huge swings are not very realistic; they are designed to illustrate the differences between the two securities.

Series I bond:
$1000 face value.
After 6 months its value is $1,060.50
After 12 months its value is $1,071.10
After 18 months its value is $1,135.91

To make the comparison fair, we’ll assume interest is also compounded for the TIP. The value we are generating is equal to the adjusted principal plus accumulated interest.

$1000 face value.
After 6 months its value is $1,060.00
After 12 months its value is $ 964.60
After 18 months its value is $1,022.48

I’m not going to claim these are the precise figures (because I have taken shortcuts on reinvesting interest payments for the TIP), but these approximations illustrate the value a Series I bond has by having a minimum interest rate applied to the accumulated bond value. Clearly, if deflation is going to occur while you are holding the bonds, the advantage goes to the Series I bonds (although standard Treasury bonds would probably do even better).

Default Risk: As with Series EE bonds, Series I bonds are issued by the Federal Government and the default risk is almost nonexistent.

Risk of Decreased Value Prior to Maturity: As previously discussed, the value of savings bonds is monotonically increasing.

TIPs pay interest twice a year and at maturity pay their adjusted principal value (but no less than the original principal). If you need to sell a TIP prior to maturity, it will be subject to market risk relative to both the real and inflation components of interest rates, as well as to whatever has already happened to the adjusted principal. There is a large secondary market in Treasuries, but you will have to pay broker costs to sell.

Call Protection: Neither Series I bonds nor TIPs are callable.

Interest Accrual Period: Series I bonds continue to accrue interest for 30 years. TIPs have maturity dates ranging up to 30 years.

Ease of Purchase: Series I bonds can be purchased directly from most financial institutions or online through TreasuryDirect®. Newly issued TIPs can also be purchased through TreasuryDirect®. You can also purchase previously issued TIPs through a broker.

Transaction Fees: There are no transaction fees to purchase or redeem savings bonds. If you buy Treasuries at auction through TreasuryDirect® there are no purchase fees. Similarly, if your TIP matures, there should be no transaction fee to surrender your security. However, if you sell a TIP before its maturity, you will be subject to broker fees.

Amount of Purchase: As discussed previously, the maximum annual purchase for each kind of savings bond (Series EE or Series I, paper or electronic) is $5,000. There are no maximum amounts for Treasuries.

All that remains to discuss is the rate of return on Series I bonds when compared to TIPs, which we’ll save for the next post.

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