With one year Treasury Bills yielding 0.35% and even the highest yielding one year Certificate of Deposit paying under 2%, investors are searching for higher returns on idle cash while maintaining safety of principal.  There have been very few options available for investors in recent months and the luxury of holding cash has meant suffering negative real returns.  An interesting opportunity now exists for investors to obtain higher yields for small amounts of cash.

Series I Savings Bonds

The Bureau of the Public Debt has announced an earnings rate of 3.36% for Series I Bonds issued between November 1, 2009 and March 31, 2010.  The fixed rate (also known as the real return) of new Series I Bonds will be 0.30%.  However, because the CPI-U inflation index rose at an annualized rate of 3.06% over the past six months, the earnings rate will be 3.36%.  This is a major improvement compared to the earnings rate of zero paid on Series I Bonds issued between April 1, 2009 and October 31, 2009.

Bond Features

Series I Bonds were introduced in 1998 to provide a way for individual investors to easily protect themselves against inflation. Series I Bonds carry a fixed rate that is set at the time of issue. The fixed rate refers to the “real return” that the purchaser will earn over the life of the bond. Series I Bonds also earn an inflation adjustment that is set every six months (on May 1 and November 1) that is based on the CPI-U inflation index. The earnings rate is derived based on the fixed rate of return and the inflation adjustment and can never fall below zero.

The terms of Series I Bonds provide many interesting features for individual investors. They are easy to purchase in small increments and do not require paying any commissions. After the first twelve months, they can be redeemed at any time although there is a three month interest penalty for any bond redeemed prior to five years. Another compelling feature is the fact that interest earned on I Bonds is tax deferred. This means that investors can accrue interest on the bonds for up to thirty years without paying income taxes on the interest that has been earned.

One major limitation of I Bonds is the annual purchase limit of $5,000.  However, this limit can be doubled by holding $5,000 in electronic form and $5,000 in paper form for an effective limit of $10,000.  Furthermore, this limit is per taxpayer ID so a married couple could invest up to $20,000 plus $10,000 per child, although this would require an actual transfer of assets to the child’s name which would use up part of the $13,000 annual gift tax exclusion.

Aren’t Series I Bonds Longer Term Investments?

The government does not want individuals to use savings bonds as short term savings instruments.  For this reason, investors are prohibited from redeeming the bonds at all during the first year of ownership.  Furthermore, any redemption prior to the five year mark results in losing the last three months of interest.

While these bonds are not intended to serve as a place to park funds needed in one year, it appears that an investor could use the bonds for precisely this purpose.  Assuming that the inflation adjustment is roughly the same when it is reset on April 1, 2010, investors would realize a return of around 3.3% on the bonds prior to the three month penalty.  The three month penalty would reduce the effective rate of interest for the year to between 2.4% to 2.5%.  This is still far in excess of other risk free alternatives for locking up funds for a year that are available today.

Risks

There are a few risks associated with using Series I Bonds for funds that are needed in one year:

1. If you require the funds prior to the one year mark, the bonds cannot be cashed and you will not have access to the funds.  Therefore, an investor must be certain that the funds will not be required for at least one year.
2. Short term interest rates on treasury bills or CDs could rise and pay a rate in excess of what can be earned with the I Bond strategy outlined in this article.  While the investor would not lose any money if this occurs, there is an opportunity cost associated with having funds locked up at sub-optimal interest rates.  At this point, few economists anticipate any imminent steep increases in the Fed Funds rate which will heavily influence Treasury Bill rates.
3. I Bond inflation adjustment rates are calculated on a six month basis.  Currently, the annualized inflation adjustment is 3.06% but this could be lower when the rate is reset in April 2010.  If this occurs, the one year result from this strategy could be lower.  However, this is partially mitigated by the fact that bonds cashed after one year will lose the last three months of interest anyway, thereby lessening the negative impact of a possible smaller inflation adjustment in April 2010.

While the approach outlined in this article is not going to result in “exciting” returns for investors, it appears that there is a good probability of realizing a larger return on cash that can be locked up for one year compared to other risk free alternatives.  The investment limit is a factor, but it would be possible for a family of four to commit up to $40,000 in I Bonds ($5,000 per person in electronic and paper bonds).

Please be aware that this article is not intended to serve as investment or tax advice.  Do your own due diligence or consult an investment or tax advisor prior to making any investment commitments.