I Bond Rates and Terms

Question

Looking at I Bonds. Can someone clarify this hypothetical situation for me?

I buy a 100 I Bond today. It earns current yield of 4.6% for the next 6 months. I never reap any "fixed" rate regardless of how long I hold it because it's currently at 0%. Even though the adjustable rate portion changes November 1, I continue to earn 4.6% through January and on February 1, my I Bond will be worth $104.60. On February 1, 2012, I start accruing interest based on the rates published on November 1, 2011.

Do I have this right?

Or maybe an example with real data from November 2010 and May 2011:

                                       Total    Total
                                       Accrued  Value
Nov-10  0.3700% 0.000616667 0.000   0.00    100.00
Dec-10  0.3700% 0.000616667 0.000   0.00    100.00
Jan-11  0.3700% 0.000616667 0.000   0.00    100.00
Feb-11  0.3700% 0.000616667 0.062   0.06    100.06
Mar-11  0.3700% 0.000616667 0.062   0.12    100.12
Apr-11  0.3700% 0.000616667 0.062   0.19    100.19
May-11  2.3000% 0.003833333 0.062   0.25    100.25
Jun-11  2.3000% 0.003833333 0.062   0.31    100.31
Jul-11  2.3000% 0.003833333 0.062   0.37    100.37
Aug-11  2.3000% 0.003833333 0.383   0.75    100.75
Sep-11  2.3000% 0.003833333 0.383   1.14    101.14
Oct-11  2.3000% 0.003833333 0.383   1.52    101.52

This sort of layout of infomration is what I am looking for to make sure I have the calculations correct.

Answer 1

If you buy an I Bond today, August 2011, the current yield would be of 4.6% as mentioned by you as the Inflation rate of May 2011 is 2.3%.

On November 2011, there will be a new Inflation rate. This rate will be used to calculate the new Composite Rate. This rate will be applicable from February 2012. lets say this rate is 4%.

So for the period August 2011 to January 2012, the rate will 4.6% annual. For the period of Feburary 2012 to July 2012 it would be 4%.

The compounding of the interest is not very clear. In the main section it mentions interest is added monthly, does it mean compounded and in a foot note of Fixed rate it mentions rate compounded semianually.

Answer 2

Your scenario is mostly correct but you are missing a few things.

The Composite Rate earned by IBonds is a factor of a fixed 'base rate' component plus a floating rate component. The actual calculation is as follows (note that a zero base rate means the second half of the calculation will always be zero):

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]

1) IBonds do not always have a zero base rate, that's just the situation for any IBond you buy at this time (largely due to low interest rates right now). IBonds have had in the past base rates that were over 3%, and could well potentially have a non-zero fixed rate portion in the future. Something to keep in mind if you hear someone bragging on an IBond that just made over 7% for them.. they probably bought ten or more years ago when the base rates were up over 3%

2) The floating rate portion is based on an annualized inflation rate, not interest rates (not sure from your question if you understood that) The specific way this is calculated is

The Series I bond inflation rate component announced in November reflects the annualized percentage change between the unadjusted March and September CPI-U indexes. The rate announced in May reflects the annualized percentage change between the September and March indexes.

3) The floating rate portion updates every six months from the purchase date of the bond, so down the road someone who purchased a month or two before or after you could for a few months be earning a different rate than you (until both of your rates are updated to the new 'six month' number) The update uses whatever rate is currently in effect at that time the bond updates. For example, a bond purchased in October will update to the rate set the prior May, and hold that rate for six months, when in April it will update to the date from the prior November.

4) The bonds Compound every 6 months, so interest will be calculated based on the balance as of the start of a 6 month period, and added the balance of the bond. At the start of the new 6 month period, the new balance used to calculate interest paid will include the interest from the prior six months.

5) your question mentioned 'terms' in the title. Under that heading be aware that you while I-Bonds can be redeemed as soon as one year after purchase, you will be penalized if you redeem sooner than 5 years after purchase.

Because of these factors, it's tricky to discuss ibonds since you might hear someone complain that their bonds are only making 'two percent' when yours are making 4%, but then a month later the other guy is still making two percent and you are making zero (a combination of the factors of base rate, and month of purchase and prior vs current floating rate)