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Out of the Cave, Into I-Bonds

Every so often something induces us fixed-income Neanderthals who continue to recommend primitive Series I U.S. Savings Bonds out of our caves and into the sunlight. Today’s post by Seeking Alpha’s Global Investing Editor on her decision not to roll her TIPS, made me want to put on my loincloth and get some fresh air.
While limited by maximum annual purchase restrictions, Series I Bonds are currently attractive because of their unique characteristics. (Note that creative use of the various registration options and use of family members as purchasers can increase annual purchases to very acceptable levels.) Here’s why I still like I Bonds for small investors:
·          Highest Credit Quality - I Bonds are full faith and credit obligations of the U.S. Government, exempt from state and local income taxes (aside – should I still be referring to the USG as “highest” credit quality?); the same as TIPS and other Treasuries
·          Inflation Protection - Interest, which is currently accruing at 3.36%, is made up of a fixed rate that stays the same for the life of the bond (currently, 0.30%) plus an inflation component that adjusts every six months based on the CPI-U (currently,  two times the semi-annual rate of 1.53%, or 3.06%); the comparable fixed rate on 5-year TIPS as of Friday’s close was 0.39%, only 9bp higher
·          Built-In Put to U.S. Treasury - The term of the bonds is 30 years, but bonds may be redeemed at any time you like after being held for one year, with the caveat that if redeemed before five years the last three months of interest is forfeited; TIPS must be resold in the open market or held until maturity
·          Tax Deferral - Interest earned each year is not recognized for federal income tax purposes until the year that the bond is redeemed (unless you elect to pay each year); you can decide to begin paying income taxes on all of your savings bonds whenever you like (possibly as part of an AMT avoidance strategy, in a year of low other income, etc.); there is no tax deferral on TIPS unless they are held in an IRA or similar account
·          Deflation Protection - In the event of a decline in the CPI-U inflation rate (deflation going forward? Ha, ha!), even if the combination of the fixed rate plus the then-current CPI-U results in a negative number, the value of a Series I bond for any particular month will not be less than the value for the preceding month; this is much better protection than is offered by TIPS  (for those of you worried about deflation; Ha, ha, again!)
·          Easy to Purchase – Definitive (paper) I Bonds may be purchased at your local bank or from the Federal Reserve Banks of Cleveland (Pittsburgh Branch) and Minneapolis whenever you like at par; unlike TIPS, there is no need to pay a broker spread or wait until an auction; they may also be purchased electronically and held in a TreasuryDirect account; but here’s a “tip”: buy I Bonds on the last day of the month and redeem them on the first day of the month because all saving bond transactions are treated by the Treasury as occurring as of the first and the full month of interest accrues as of the first regardless of the day actually redeemed
As I mentioned above, the worst thing about I-Bonds is the annual purchase limitation. Otherwise, if you believe as I do that the CPI-U is unlikely to decline meaningfully, they would beat all other short-term, U.S. Treasury-quality alternatives as follows: buy on the last day of a month (say January 31, 2010) and redeem January 2, 2011, earn ten months of interest (thirteen month investment less the three month penalty) on an eleven month (plus a day or two) investment at an approximate APR of about 3%. Actually, you can do this trade, but just not in size.

Disclosure: Long I Bonds and TIPS.