One of the disadvantages of bonds is that they usually offer a fixed interest rate. Once a bond is issued, its interest rate typically cannot adjust as expected inflation changes. This presents a serious risk to bond investors because if inflation rises while the nominal rate on the bond remains fixed, the real rate of return falls. The U.S. Treasury Department now offers the I-bond, which is an inflation adjusted savings bond. A Series-I bond earns interest through the application of a composite rate. The composite rate consists of a fixed rate that remains the same for the life of the bond and an adjustable rate equal to the actual rate of inflation. The adjustable rate changes twice per year and is based on movements in the Consumer Price Index for All Urban Consumers (CPI-U). This index tracks the prices of thousands of goods and services, so an increase in this index indicates that inflation has occurred. As the rate of inflation moves up and down, I-bond interest rates adjust (with a short lag). Interest earnings are exempt from state and local income taxes, and are payable only when an investor redeems an I-bond. I-bonds are issued at face value in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. The I-bond is not without its drawbacks. Any redemption within the first 5 years results in a 3- month interest penalty. Also, you should redeem an I-bond only at the first of the month because none of the interest earned during a month is included in the redemption value until the first day of the following month. The adjustable-rate feature of I-bonds can work against investors (that is, it can lower their returns) if deflation occurs. Deflation refers to a general trend of falling prices, so when deflation occurs, the change in the CPI-U is negative, and the adjustable portion of an I-bond’s interest also turns negative. For example, if the fixed-rate component on an I-bond is 2 percent and prices fall 0.5 percent (stated equivalently, the inflation rate is –0.5 percent), then the nominal rate on an I-bond will be just 1.5 percent (2 percent minus 0.5 percent). Nevertheless, in the past 80 years, periods of deflation have been very rare, whereas inflation has been an almost ever-present feature of the economy, so investors are likely to enjoy the inflation protection that I-bonds offer in the future. Question: What effect do you think the inflation-adjusted interest rate has on the price of an I- bond in comparison with similar bonds with no allowance for inflation?
I-Bonds Adjust for Inflation
One of the disadvantages of bonds is that they usually offer a fixed interest rate. Once a bond is
issued, its interest rate typically cannot adjust as expected inflation changes. This presents a
serious risk to bond investors because if inflation rises while the nominal rate on the bond
remains fixed, the real
which is an inflation adjusted savings bond. A Series-I bond earns interest through the
application of a composite rate. The composite rate consists of a fixed rate that remains the
same for the life of the bond and an adjustable rate equal to the actual rate of inflation. The
adjustable rate changes twice per year and is based on movements in the Consumer Price
Index for All Urban Consumers (CPI-U). This index tracks the prices of thousands of goods and
services, so an increase in this index indicates that inflation has occurred. As the rate of inflation
moves up and down, I-bond interest rates adjust (with a short lag). Interest earnings are exempt
from state and local income taxes, and are payable only when an investor redeems an I-bond.
I-bonds are issued at face value in denominations of $50, $75, $100, $200, $500, $1,000, $5,000,
and $10,000.
The I-bond is not without its drawbacks. Any redemption within the first 5 years results in a 3-
month interest penalty. Also, you should redeem an I-bond only at the first of the month
because none of the interest earned during a month is included in the redemption value until the
first day of the following month. The adjustable-rate feature of I-bonds can work against
investors (that is, it can lower their returns) if deflation occurs. Deflation refers to a general trend
of falling prices, so when deflation occurs, the change in the CPI-U is negative, and the
adjustable portion of an I-bond’s interest also turns negative. For example, if the fixed-rate
component on an I-bond is 2 percent and prices fall 0.5 percent (stated equivalently, the inflation
rate is –0.5 percent), then the nominal rate on an I-bond will be just 1.5 percent (2 percent minus
0.5 percent). Nevertheless, in the past 80 years, periods of deflation have been very rare, whereas
inflation has been an almost ever-present feature of the economy, so investors are likely to enjoy
the inflation protection that I-bonds offer in the future.
Question: What effect do you think the inflation-adjusted interest rate has on the price of an I-
bond in comparison with similar bonds with no allowance for inflation?
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