I Bond investor's timing is vital, as rates may change

By Sandra Block
USA Today

Thanks to a spike in oil prices, the interest rate on inflation-adjusted savings bonds might edge above 5 percent on Thursday, more than double the rate paid by other low-risk investments.

Rates on I Bonds are based on two components: a fixed rate, which stays the same for the life of the bond, and a variable rate tied to the consumer price index that might be adjusted every six months. Because gasoline prices have pushed the index higher, bond analysts believe the combined rate could rise to 5.16 percent on May 1, vs. the current 4.08 percent.

By comparison, short-term certificates of deposit pay less than 2 percent; money market funds, less than 1 percent.

Over a six-month period, a $30,000 investment in an I Bond paying 5.16 percent would earn $774, vs. about $109 from the average money market fund.

EE Bonds, which pay a rate tied to five-year Treasury notes, pay 3.25 percent. That rate is also recalculated every six months, and is expected to fall to 2.5 percent or 2.75 percent on Thursday.

For interest-hungry investors, timing is critical, says Dan Pederson, author of "Savings Bonds: When to Hold, When to Fold and Everything in-Between." In an effort to bring rates on I Bonds in line with other government-insured investments, Treasury reduced the fixed rate, now 1.6 percent, several times in recent months. Treasury might reduce it again on Thursday, he says.

If that happens, investors who buy I Bonds after Wednesday will get a lower combined rate. For example, if Treasury lowered the fixed rate to 1 percent, investors would get a 4.56 percent rate for the next six months.

Treasury officials declined to comment on what will happen.

Pederson's solution: Buy before Wednesday, locking in the 1.6 percent rate. Investors who take his advice would be earning 4.08 percent until October. But on Oct. 1, the rate could rise to 5.16 percent and stay there until April 1, 2004. At those rates, $30,000 invested in an I Bond for one year would earn $1,380, vs. $516 for the average one-year CD.

Under the rules, investors are required to hold their bonds for at least 12 months. Owners who cash out in less than five years give up three months' interest. But the premium paid by I Bonds makes them attractive for investors who might need the money in a year or two, Pederson says.

For example, an investor who bought an I Bond before Wednesday and sold it a year later would still end up with an effective rate of about 3.3 percent, he says. That's about three times the interest on most money market funds, he says.

Other advantages to I Bonds:

• Interest is exempt from state and local taxes; federal tax isn't due until the bond is redeemed.
• I Bonds can be purchased for as little as $50, or $25 if they're purchased online from www.treasurydirect.gov. The maximum investment is $30,000 a year. A married couple can invest up to $60,000 a year.

Investors funneled $6.2 billion in I Bonds in fiscal 2002 — up 76 percent from fiscal 2001, Treasury says.