Type "I" savings bonds game plan

http://bankdeals.blogspot.com/2008/04/next-i-bond-inflation-component-will-be.html

The Labor Department released the March CPI numbers today, and with these numbers, the I Bond inflation component can be computed. Thanks to the recent inflation, it's a very high 4.83%. The only time this rate has been higher was in November 2005 which was after the Katrina-induced energy price spike. This 4.83% number is added on to the I Bond fixed rate to derive the I Bond composite rate.

The new rate makes an attractive no-risk opportunity. However, with the new annual I-Bond purchase limit of $5,000 online and $5,000 paper, the opportunity is limited.

If you buy I Bonds before the end of April, you can know the rate you'll receive for the next 12 months. The interst rate for the first 6 months will be based on the current inflation componet (3.06%). The next 6 months should be based on this new rate (4.83%). After that, it'll depend on future inflation numbers. The current fixed component of 1.2% will stay the same for the life of the bond. I describe the details of calculating the expected return below.

If you decide to wait after April to buy I Bonds, you'll have to guess about the next fixed rate component. Currently, it's 1.20%. I have a feeling it's likely to drop. Based on the low TIPs rates (see article) and the low interest rate environment, I think there's a good chance the Treasury will drop the rate to 1% or lower. The lowest it has ever been is 1% (see I Bond rate history). The only thing that may encourage the Treasury to increase the rate would be to compensate for the slashing of the annual purchase limit. But I don't give this much weight.

Estimating I Bond rate of return for the next 11 to 14 months

From Treasury Direct I Savings Bonds FAQs
The semiannual inflation rate announced in May is the change between the CPI-U figures from the preceding September and March

All previous CPI-U numbers are available from this government webpage. The CPI-U for September 2007 was 208.49. Last March 2008 CPI-U was 213.528. This is an increase of 2.4164%. The annualized version of this is about 4.83%.

If you buy before May, you'll receive the current I-Bond fixed rate of 1.2% for the life of the I-Bond. The inflation component will be added to this rate and will change every 6 months. The current inflation component is 3.06%, and the composite rate is 4.28%. Here's an estimate of the return for the next year:
4.28% from April 2008 to September 2008
6.06% from October 2008 to March 2009

I Bonds increase in value on the first day of the month. So on May 1 2008, you'll earn the interest for the full month of April. So for maximum return, it's best to buy I Bonds near the end of the month and redeem them early in the month.

If you buy them on April 30, 2008, the value of the I Bond on April 1, 2009 would be about 5.17% higher. For 11 months, this comes out to an annualized yield of about 5.64%.

If you want to redeem them on April 1, 2009, you'll be hit with a penalty of 3 months interest (the most recent months). So if you want to maximize the time you earn 6.06%, you'll want to hold on to them for 3 more months.

Below is an estimated annualized return for I Bond redemptions from April 1, 2009 to July 1, 2009. It is assumed you bought the I Bond on April 30, 2008 which gives you almost an extra month of interest.
3.99% - redeem on 4/1/09, 6mo of 4.28%, 3mo of 6.06%, and 3mo penalty
4.16% - redeem on 5/1/09, 6mo of 4.28%, 4mo of 6.06%, and 3mo penalty
4.31% - redeem on 6/1/09, 6mo of 4.28%, 5mo of 6.06%, and 3mo penalty
4.43% - redeem on 7/1/09, 6mo of 4.28%, 6mo of 6.06%, and 3mo penalty

The highest guaranteed rate would be an annualized return of 4.43% for about 14 months (from 4/30/08 to 7/1/09).

Note, it's best not to wait until the last day of the month to buy I Bonds at Treasury Direct. You probably want to give yourself a few days to ensure they are officially purchased before the end of the month.

Below is a summary of the I Bond features. More information is available at this Treasury I Bond page:
Can't be redeemed within 12 months of issue date
Lose 3 months interest if redeemed within 5 years
Interest is composed of fixed and inflation-based rate
Fixed rate remains for life of bond
Inflation-based rate changes every 6 months after issue date
New rates announced every six months on November and May 1st
Federal tax can be deferred on interest until bond is redeemed
Interest is exempt from state and local tax
Some or all interest is tax exempt when used for educational expenses
$10,000 maximum of I Bond purchases per year ($5K online and $5K paper) - total was $60,000 before 2008 (Treasury's press release).

For more details about the purchase limit, please refer to the Treasury Direct's FAQ on the new purchase limit.