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URL:  http://boards.fool.com/can-you-elaborate-on-this-please-i-hear-a-lot-30497756.aspx

Subject:  Re: Fire Update 2012 Date:  1/21/2013  3:58 PM
Author:  warrl Number:  4976 of 5068

Can you elaborate on this, please? I hear a lot of people mentioning I-bonds as a part of their portfolios. Are they just a substitute for holding some type of bond fund?

Ibonds are marketed as being immune to inflation risk, but they are merely somewhat resistant. Highly resistant in a tax-sheltered account or if used for certain educational expenses, but only moderately resistant otherwise.

An Ibond is a zero-coupon bond. That means you don't actually get paid interest over time; instead the interest is added (every six months) to your basis, and that's what draws interest for the next six months.

The interest has two components: a fixed portion (which has been zero since 11/1/2010) and an inflation portion (which is computed every six months based on the six-month change in CPI-U). These are combined through a formula to produce a composite annual rate, half of that rate (because it's an annual rate and you're getting six months interest) is applied to your current basis, and that result is what actually gets credited to your basis.

The catch is that every part of the interest is taxable when it is credited to your basis, even though you have no actual income.

Now the current fixed rate is zero, which means the composite rate consists solely of the inflation portion. It's 1.76%. And if it's taxable, you're guaranteed to be losing purchasing power.

And of course there's the question of whether CPI-U is a realistic and accurate measure of inflation. I won't comment on whether the government IS fudging the numbers (or deliberately choosing methodologies designed to cause understatement) on it; I'll merely point out that they have plenty of incentive to do so - and that incentive goes up in proportion to actual inflation.
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