Treasury I-Bonds Question

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Calculating I Bonds returns isn't as easy as it looks. Sometimes the short term rate works against you.

Inflation Adjusted Bonds (I Bonds)

Why are my "I-Bonds" paying so little?

Recently I received this question about I-bonds. I-bonds are inflation adjusted Treasury bonds. The amount they pay is adjusted twice a year to compensate for the effects of inflation.

I am a holder of Treasury I bonds (adjusts to the CPI every May & Nov.) Last November the CPI that Treasury used was 2.8, which when adjusted to one year and added to the base rate of the bond resulted in a total return of 6.73%.

On May 1, 2006 Treasury used a CPI rate of .50, which when adjusted and added to the base rate of the bond results in a total return of 2.41%.

QUESTION: How is is possible in this inflationary period for such a dramatic reduction to occur?

Thank you, Herman R.

Here is my response:

Herman,

Very good question! Here are the monthly inflation numbers. The problem is that the major portion of the Annual inflation occurred in the first half of the year i.e. the months of Apr, July, Aug, & Sept 2005.

But October 2005 through Mar 2006 had several strongly negative months. So since they calculate based on a 6 month time frame you got stuck basically due to the effects of Katrina and a 6 month time frame.

Inflation Rates	Mar 05	Apr 05	May 05	Jun 05	Jul 05	Aug 05	Sep 05	Oct 05	Nov 05	Dec 05	Jan 06	Feb 06	Mar 06
1 Mo.	0.78%	0.67%	-0.10%	0.05%	0.46%	0.51%	1.22%	0.20%	-0.80%	-0.40%	0.76%	0.20%	0.55%
6 Mos.	1.79%	1.94%	1.78%	2.21%	2.46%	2.40%	2.85%	2.36%	1.65%	1.18%	1.48%	1.17%	0.50%
Annual	3.15%	3.51%	2.80%	2.53%	3.17%	3.64%	4.69%	4.35%	3.46%	3.42%	3.99%	3.60%	3.36%

What happened was Katrina caused an abnormally high short-term spike in September but by November and December rates fell back to "normal" levels creating deflation (falling prices) for those months.

So in effect you benefited from higher 6 month inflation numbers last year and are paying for it this year. Had they taken actual numbers for a whole year (rather than multiplying 6 months times 2) things would have looked differently.

It looks like they used the September numbers (2.8%) for your November calculation (note they round to one decimal place we round to two.) They would have used a 4.69% (4.7%) inflation rate from September 05 and a 3.36% (3.4%) inflation rate from March 06.

So here's how it worked-- they multiplied (the numbers from September) 2.8% x 2 to get 5.6% and then added a factor of 1.13% to get a total of 6.73% for November 2005. Had they used the full year instead they would have added 1.13% to 4.7% and given you 5.83%. so you gained .90% last time. (6.73% that you got minus. 5.83% that you should have gotten).

This time it works against you. They took .5% x 2 to get 1% and added a factor of 1.41% giving you 2.41%. If they had used the annual rate of 3.4% and added 1.41% you would have gotten 4.54% so you lost 2.13%. At this point it looks bad but I would think over the long term it should balance out, but it would be interesting to see if it really does.

Hope This Helps,

Timothy McMahon, Editor
Financial Trend Forecaster
The Web's Premiere Inflation Website
www.Fintrend.com
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