Finance: You can panic now, or panic later
TheStreet.com contributor Terry Savage is advising people to load up on I Bonds before a likely rate decrease on May 1.
Her math is approximately correct, but I'm not sure she really understands why that is. She carries on too long about the "complexity" of the Fed's methods in calculating I-bond interest rates, and not nearly long enough in explaining the justification of a panic purchase. The Fed's methods do involve multiplication and addition, but it's not "calculus" as she calls it. Most important, there are gobs of alternatives that will pay more interest than an urgent I Bond purchase... with none of the panic.
Here's the deal: I Bonds pay interest based on a two-part formula. Part of the bond's interest rate is set when the bonds are issued, and part of the rate is adjusted every six months (November 1 and May 1). For example, I bonds issued between Nov. 2005 and now have a 1.0% fixed rate, and a 5.7% inflation-adjusted rate for a "composite rate" of 6.73% (the extra .03% comes from the Fed's formula - look it up below). This is a very high rate, relative to other investments. It occurred because the two sampled months had a big disparity in their Consumer Price Index figures. It's a bit of an anomaly actually... but because I bonds are designed for long-term investment, these things do average out in the end so while the Fed's methods are vulnerable to short-term blips, over the long haul, it's all rational.
By the way, if you want to know more about I Bonds and rate calculations, the US Treasury publishes comprehensive online resources that will tell you all you need to know, so I won't fill this space with empty repetition of their work.
Savage is flapping her arms yelling "buy I bonds now!" because it seems inevitable that the May 1 adjustment will see a big decrease in I bond rates. The previous rate was high because of a blip, and inflation over the recent 6 months was low. I Bonds are inflation-indexed, so... inflation goes down, I Bond interest rates go down.
Savage says investors must lock in that darling 6.73% rate now.. today... Friday... Monday's too late...
I'm pretty sure this is lousy advice. Savage has failed to consider alternative investment vehicles for money that would go into those I Bonds, and she isn't counting the costs of disposing of the bonds if the interest situation doesn't improve after a year.
The problem is that once the rate drops to 2.0%, that 6.73% over six short months hasn't earned the investor very much money, but has created a lot of bother with rules about selling the bonds, possible interest penalties, and worst of all, a panicky "buy now" imperative.
The effective interest rate on these bonds for the first year, using her figures (assuming the May 1 rate will be 2.00%) is (6.73% + 2.00%) / 2 = 4.365% or a bit lower if you sell the bond at the end of the year, due to penalties. There's an example below with real numbers filled in, to illustrate where the money comes from and goes.
So, an I Bond might earn you 4.365% for year 1, free of state and local taxes.
What alternatives exist to I Bonds that don't have the uncertainty and the assured low rate? That's an easy one.
Other government securities
Monday's 6-month rate for US Treasury Bills was 4.919%. T bills are state/local tax free, and the investment terminates after 6 months with no penalties or other obligations. You can also ease your way into these over several weeks if you don't want to commit to a single moment's rate -- T bills are auctioned every Monday.
Good old CDs
BankRate.com is showing one year Certificates of Deposit paying up to 5.35% APY. Assuming a 10% tax rate on the interest and no deductions to offset it, that's an effective after-tax yield of around 4.815% in a simple, insured form that terminates after a year, and the banks will be there to take your call today, Monday, or whenever you are ready.
To recap, the best case for I Bonds is a 4.365% return... the worst case for a simple 1-year CD considering 10% tax overhead is 4.815%, and the worst case for T bills is 4.919% (give or take a few small decimals).
There is no reason at all to buy I Bond right now considering the looming rate reduction. Even those investors who want to stay in Fed securities would be better off moving into T bills or CDs for the near term, then revisiting the I Bond situation in October when the Consumer Price Index that drives the November variable rate will be known. For a tax-advantaged account such as an IRA, the interest rate is all that matters, so CDs make even more sense than T Bills or Bonds, if your IRA custodian offers high-rate CDs.
I think the Fed will raise the fixed rate at least a little to get it off the 1.00% mark where it's been stuck for more than a year. They can't sell this product if it's only earning 2.0%, and the fixed rate is totally at the Fed's discretion. In the past it has dropped as much as 1.00% from one 6-month period to the next. And the fixed rate has not been bumped up since the Fed's interest rate increases began... it's overdue.
Repeating... explore alternatives... take a deep breath... no need to rush into anything...
EXAMPLES, rounded generously
I Bond purchased April 27, 2006:
$10,000 @ 6.73% for 6 months (April-Sept) = $340
$10,340 @ 2.00% for 6 months (Oct-March 2007) = $110
Total for first year: $10,450
If rates don't increase, you'd want to sell this bond
Penalty for selling after 1 year: $55 (last 3 months' interest)
Net after 1 year: $10,395 (Sell) to $10,450 (hold) free of state and local taxes
Certificate of Deposit, 1 year at 5.30% APY
$10,000 @ 5.30% = $10,530
10% taxes = $105
Net after 1 year: $10,425 after 10% state and local taxes
T Bill (using 4.919% rate from April 24 for 6 months, and guessing 4.5% worst case for the 2nd six months)
$10,000 @ 4.919% for 6 months = $246
$10,246 @ 4.500% for 6 months = $231
Net after 1 year: $10,477 free of state and local taxes
Her math is approximately correct, but I'm not sure she really understands why that is. She carries on too long about the "complexity" of the Fed's methods in calculating I-bond interest rates, and not nearly long enough in explaining the justification of a panic purchase. The Fed's methods do involve multiplication and addition, but it's not "calculus" as she calls it. Most important, there are gobs of alternatives that will pay more interest than an urgent I Bond purchase... with none of the panic.
Here's the deal: I Bonds pay interest based on a two-part formula. Part of the bond's interest rate is set when the bonds are issued, and part of the rate is adjusted every six months (November 1 and May 1). For example, I bonds issued between Nov. 2005 and now have a 1.0% fixed rate, and a 5.7% inflation-adjusted rate for a "composite rate" of 6.73% (the extra .03% comes from the Fed's formula - look it up below). This is a very high rate, relative to other investments. It occurred because the two sampled months had a big disparity in their Consumer Price Index figures. It's a bit of an anomaly actually... but because I bonds are designed for long-term investment, these things do average out in the end so while the Fed's methods are vulnerable to short-term blips, over the long haul, it's all rational.
By the way, if you want to know more about I Bonds and rate calculations, the US Treasury publishes comprehensive online resources that will tell you all you need to know, so I won't fill this space with empty repetition of their work.
Savage is flapping her arms yelling "buy I bonds now!" because it seems inevitable that the May 1 adjustment will see a big decrease in I bond rates. The previous rate was high because of a blip, and inflation over the recent 6 months was low. I Bonds are inflation-indexed, so... inflation goes down, I Bond interest rates go down.
Savage says investors must lock in that darling 6.73% rate now.. today... Friday... Monday's too late...
I'm pretty sure this is lousy advice. Savage has failed to consider alternative investment vehicles for money that would go into those I Bonds, and she isn't counting the costs of disposing of the bonds if the interest situation doesn't improve after a year.
The problem is that once the rate drops to 2.0%, that 6.73% over six short months hasn't earned the investor very much money, but has created a lot of bother with rules about selling the bonds, possible interest penalties, and worst of all, a panicky "buy now" imperative.
The effective interest rate on these bonds for the first year, using her figures (assuming the May 1 rate will be 2.00%) is (6.73% + 2.00%) / 2 = 4.365% or a bit lower if you sell the bond at the end of the year, due to penalties. There's an example below with real numbers filled in, to illustrate where the money comes from and goes.
So, an I Bond might earn you 4.365% for year 1, free of state and local taxes.
What alternatives exist to I Bonds that don't have the uncertainty and the assured low rate? That's an easy one.
Other government securities
Monday's 6-month rate for US Treasury Bills was 4.919%. T bills are state/local tax free, and the investment terminates after 6 months with no penalties or other obligations. You can also ease your way into these over several weeks if you don't want to commit to a single moment's rate -- T bills are auctioned every Monday.
Good old CDs
BankRate.com is showing one year Certificates of Deposit paying up to 5.35% APY. Assuming a 10% tax rate on the interest and no deductions to offset it, that's an effective after-tax yield of around 4.815% in a simple, insured form that terminates after a year, and the banks will be there to take your call today, Monday, or whenever you are ready.
To recap, the best case for I Bonds is a 4.365% return... the worst case for a simple 1-year CD considering 10% tax overhead is 4.815%, and the worst case for T bills is 4.919% (give or take a few small decimals).
There is no reason at all to buy I Bond right now considering the looming rate reduction. Even those investors who want to stay in Fed securities would be better off moving into T bills or CDs for the near term, then revisiting the I Bond situation in October when the Consumer Price Index that drives the November variable rate will be known. For a tax-advantaged account such as an IRA, the interest rate is all that matters, so CDs make even more sense than T Bills or Bonds, if your IRA custodian offers high-rate CDs.
I think the Fed will raise the fixed rate at least a little to get it off the 1.00% mark where it's been stuck for more than a year. They can't sell this product if it's only earning 2.0%, and the fixed rate is totally at the Fed's discretion. In the past it has dropped as much as 1.00% from one 6-month period to the next. And the fixed rate has not been bumped up since the Fed's interest rate increases began... it's overdue.
Repeating... explore alternatives... take a deep breath... no need to rush into anything...
EXAMPLES, rounded generously
I Bond purchased April 27, 2006:
$10,000 @ 6.73% for 6 months (April-Sept) = $340
$10,340 @ 2.00% for 6 months (Oct-March 2007) = $110
Total for first year: $10,450
If rates don't increase, you'd want to sell this bond
Penalty for selling after 1 year: $55 (last 3 months' interest)
Net after 1 year: $10,395 (Sell) to $10,450 (hold) free of state and local taxes
Certificate of Deposit, 1 year at 5.30% APY
$10,000 @ 5.30% = $10,530
10% taxes = $105
Net after 1 year: $10,425 after 10% state and local taxes
T Bill (using 4.919% rate from April 24 for 6 months, and guessing 4.5% worst case for the 2nd six months)
$10,000 @ 4.919% for 6 months = $246
$10,246 @ 4.500% for 6 months = $231
Net after 1 year: $10,477 free of state and local taxes
1 Comments:
I really don't see where Savage is "advising people to load up on I Bonds" or "flapping her arms yelling 'buy I bonds now!'". Not at all.
Yes, at least a simple-minded list of alternatives should have been included... and the whole "math is hard!" attitude was insulting...
but this is the ONLY article I saw that warned of the coming rate drop, so let's at least give credit for that. I was starting to think I was the only person that saw it coming. March CPI was announced on 4/19, and it was obvious long before that CPI was simply not moving that much. A serious journalist would have had an article ready and waiting on the morning of the 19th, waiting for the final number to fill in. (Maybe she did, but had to call JPL to have the computers run that "complex" formula to get the new rate.)
None of this excuses the rest of the media for completely ignoring this. I Bonds have clearly never been sexy enough to warrant any attention... even though my 2001 bonds with a 3% fixed rate were earning 4-6% back when bank savings paid practically nothing.
I jumped on the 6.73% gravy train again last November (waiting till the end of the month to buy a bond with an issue date of 11/1, a trick the media never mentions), fully expecting the rate to drop after 6 months and expecting the overall result to at least be on par with CD's, and hopefully somewhat better. Sure enough, if I sell them on 11/1/06 I'll have earned 3.95% in 11 months.
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