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United State Treasury Series I Bonds

I Bonds are designed for investors seeking protection and a “real” rate of return.

By Michael R. Harris

The yields of “Series I Savings Bonds” presently exceed those of many other five-year investments, and in fact produce a greater yield than many listed investments for any period except the yield for long-term municipal bonds (after adjustment to reflect their tax-exempt status.)

What are Series I Bonds?
They are United State Treasury Bonds designed for investors seeking to protect their purchasing power and to earn a guaranteed “real” rate of return. They are an accrual type security. I Bonds increase in value on the first day of each month, but interest is compounded only semi-annually. Interest is received when the bond is redeemed or otherwise disposed of.

The earnings rate of these bonds is a combination of two separate rates, a fixed rate of return, and a variable semi-annual inflation rate. The fixed rate is determined when the bond is purchased and remains the same throughout the life of the bond. The semi-annual inflation rate can vary and be adjusted every six months.

The fixed rate of return is announced by the Treasury Department each May and November, and remains applicable for the entire life a bond that is purchased during the following six months. The semi-annual inflation rate is also announced each May and November by the Treasury Department, and is based on changes in the Consumer Price Index for all urban consumers that are reported by the Bureau of Labor Statistics. The rate that is announced is a measure of inflation over the preceding several months.

The semiannual inflation rate is combined with the fixed rate of the bond pursuant to a formula to determine the bond’s earnings for the next six months. The bonds provide that if there is a negative cost of living adjustment large enough to offset the fixed rate of return, the value of the bonds will not decline. Instead, the value of the bonds will remain the same until the earnings rate becomes greater than zero.

The bonds are Treasury securities backed by the U.S. government and have a term of up to 30 years. Earnings are exempt from state and local income taxes. Federal income taxes are deferred until redemption or other taxable disposition of the bond occurs.

All or part of the interest on the bonds can be excluded from income as long as the proceeds are used to pay for tuition and fees at eligible post-secondary educational institutions.

Bonds are available in denominations of $50 to $10,000 and are issued at face value. An individual can purchase no more than $30,000 of Series I bonds in a calendar year. Bonds can be purchased and redeemed through most local financial institutions.

Penalties and Restrictions
There are some restrictions or penalties on redemption. Bonds cannot be redeemed for the first six months after issuance. Thereafter, they can be redeemed, but there is a penalty of three months earnings if the bonds are redeemed within the first five years after issuance.

The earning rate of these bonds, effective November 1, 2001 through April 1, 2002, is 4.40 percent, composed of a fixed rate component of two percent, and an inflation rate adjusted to 2.4 percent. A new rate will be calculated and announced in May 2002 and will apply for the following six months.

If there are significant changes in the components of the fixed interest portion of the rate calculation during a six-month period, reviewing the situation near the end of the period is a good idea. If interest rates have fallen, these investments are more appealing because they reflect earlier higher rates. On the other hand, they are less appealing if interest rates have risen. The method of setting the fixed interest portion of the rate seems to give the investor the benefit of several months “hindsight.”

I Bonds, (though limited in the amount available each year) are an investment to consider for those fortunate investors who feel that they can wait for five years after investing before beginning to receive income, and would then have an adequate income flow at the fixed rate at which the bonds are presently selling (currently two percent and taxable when received.)

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Michael R. Harris, of Blank Rome, LLP, practices in the firm's Boca Raton FL and Philadelphia PA offices. He can be reached at 561-417-8105 or 215-569-5315 or harris-mr@blankrome.com.