I Bond interest rates expected to drop to zero percent

I've been asked this question thousands of times since the start of the Series I Bond program in 1998 and it's finally making headlines: "If inflation dropped to zero, or there's a recession, what will happen to the interest rate of I Bonds?"

Recession, deflation or economic slowdown; any way you put it, it spells disaster for I Bonds. The I bond was originally introduced to be a hedge against inflation, but what will happen when there's no inflation? Well, savings bond owners are about to find out this Friday, May 1.

During the past four or five months, the country has actually been experiencing deflation at a factor of approximately minus 5.3%, according to the Urban Consumer Price Index (CPI-U) calculated by the government. Since the interest rate for the I Bond is a composite of an inflation rate and a fixed rate, there is widespread anticipation that the new I Bond will be close to 0% for the next six month interest earnings cycle.

Using common math, the new I Bond interest rate would be a negative factor, somewhere around -4.6%. However, when the first I Bond was originally issued back in September of 1998, the government made a promise that the interest rate would never be less than 0%. I Bond rules also state that no bond would ever lose value or interest for its lifetime. So while other investments have lost a significant portion of their worth, savings bonds will not lose any of their value ... but they certainly wont be gaining any either.

So what does that mean to the investor who already owns I Bonds?

Your bonds will probably not grow appreciably for the six month period starting with the month that your bond was originally issued. But once November arrives, the new interest rate calculation cycle will begin again.

Assuming that the country will continue to work itself out of the economic recession during the remainder of 2009, interest rates will start to ratchet up once again. There will most likely be a cycle of inflation for at least two or three years. So the temporary hiatus with savings bond interest rates will abate and the growth in value of everyone's savings bonds will resume as in the past.

While the I Bond seems to be set up for controversy come Friday's rate announcements, Series EE Bonds are still earning a positive rate of interest. Back in May of 2005, the Treasury Department decided to issue new EE Bonds with a fixed interest rate for the first 20 years of its interest bearing life.

The most recent interest rate for EE Bonds -- purchased between Nov 1, 08 through April 30, 09 -- was 1.30%, with a guarantee that the EE Bond will be worth at least its face value on the bond's 20th anniversary, with a final maturity 10 years after that. Overall the effective yield of an EE Bond at its first 20 years will result in a 3.5% yearly return.

There is some speculation that the government might actually use this economic recession as an excuse to discontinue issuing Series EE Bonds altogether.

Check back again on Friday to see what actually happens to savings bond interest rates for the next six months.

Jack Quinn is a personal finance writer and editor for SavingsBonds.com. Jack has helped Savings Bond owners better understand their investments for more than 15 years.

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