With rates up, I Savings Bonds look better than ever

If you haven't yet invested in I Savings Bonds, this is the time.

At the May 1 interest-rate setting, new I Savings Bonds were set to yield 1.20 percent plus the rate of inflation. That rate, calculated from September 2004 to March 2005, was 3.58 percent, bringing the annualized yield to a 4.80 percent rate over the next six-month period, according to the Bureau of the Public Debt.

After that, the yield will be reset every six months based on the fixed real return of 1.2 percent plus the new trailing inflation rate. To put that 4.80 percent yield in perspective, Bloomberg.com tells us the yield on 30-year Treasuries is only 4.51 percent. It's 4.19 percent on 10-year Treasuries and 3.88 percent on five-year Treasuries.

While we can hold I Savings Bonds for as long as 30 years with interest tax deferred, we can't redeem them before five years without a penalty of three months' interest. The long-term yield may be uncertain, but these securities currently offer more yield with less risk.

Junk-bond funds are one of the few investments that provide a higher yield than I Savings Bonds — they provide an average yield of 5.79 percent. But you have to accept high interest-rate risk, credit risk and liquidity risk.

If interest rates rise, the market value of bonds in mutual-fund portfolios will decline. If you buy an I Savings Bond, the worst that can happen is that you can take a penalty of three months' interest if you redeem the bond before five years. After five years, you can redeem it with no penalty.

History makes these bonds look good as well. According to Ibbotson Associates, the Chicago firm that tracks historical asset returns, Treasury bills provided a real, after-inflation return of 0.7 percent a year from 1926 through 2004. The current return on I Savings Bonds is 1.2 percent, and it's certain.

Intermediate government bonds provided a real return of about 2.4 percent through the same period, but whether you actually got the real return depended on when you were investing.

T-bills, for instance, provided a real return of 2.5 percent through the 1930s — largely because of deflation and the Great Depression. Indeed, in 1938, 1939 and 1940, T-bills provided no yield.

T-bills provided a real return of 3.8 percent in the '80s as then-Fed Chairman Paul Volcker worked to end inflation. They brought a real return of 2 percent through the '90s for the same reason.

But if you had invested in Treasury bills in the 1940s, the 1950s, the 1960s or the 1970s, your real return would have been negative each decade. Real returns on intermediate-term government bonds were negative in 25 of the same 40 years.

If you think we are heading for a major depression and deflation, I Savings Bonds aren't a good buy.

But if you think we are heading for renewed (or just continued) inflation, I Savings Bonds are the best game in town.

History tells us the odds favor inflation.

Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at scott@scottburns.com. Questions of general interest will be answered in future columns.