March 4th, 2013 by Karl
A common question asked by novice investors is “How do savings bonds work?” Most likely, your only existing exposure to savings bonds lies in your childhood. You probably received one as a birthday gift from your least favorite Aunt – when you really wanted that awesome new Teenage Mutant Ninja Turtle action figure, or a Polly Pocket play set.
You were soured on US savings bonds at that point, and probably never looked into them again.
How Do United States Savings Bonds Work?
There are four different types of savings bonds, discussed below. Each one works slightly differently, but the concept is generally the same for all of them. You purchase a savings bond with a fixed amount of cash – $25, $50, $75, $100, $200, $500, $1000, $5000, or $10,000. You then collect interest on the bond until you cash it out. Like most other investments, cashing out early will result in penalties, reducing the total amount that you earn on the investment.
It’s very difficult to pinpoint an average rate of return of savings bonds, as the interest rates vary depending on when they were purchased. If you own an I bond, your interest rate fluctuates annually based on the rate of inflation, which makes it even more difficult to pinpoint an average rate of return.
The biggest benefit to purchasing US Savings Bonds is the fact that they’re backed by the government. As long as the US Government doesn’t go bankrupt and you allow the bond to mature, you’re guaranteed to get your money back.
One thing to consider is what these bonds really are – a form of savings. The rates of return tend to be relatively insignificant when compared to other investments, and at times, traditional savings accounts may even outpace their rate of return.
As a long-term system for wealth preservation, they’re not that great. If, however, you’re hoping to add a very safe item to your portfolio (or hoping to help a kid learn the basics of investing) they’re a great option.
Finally, they’re “not marketable,” meaning only the United States Treasury department can sell them. It used to be that you would go to your local bank to buy them, and you’d get a “paper” bond (basically, a certificate showing the details of your investment). Now, they’re all sold digitally.
Different Types of Savings Bonds
Let’s start by cutting out the two types of savings bonds that just don’t matter, anymore:
- Series HH/H Bonds – They haven’t been issued since 2004, and there’s no way to purchase them. They earned as much as 4.00% annually, and interest was paid directly to your bank account. They were taxable on the federal level, but not by your local state government. If you own any of these, you can cash them out right now, without penalty – the minimum time to maturation was six months, meaning that they’ve all matured long ago.
- Patriot Bonds – These bonds were issued at your local bank and differed from EE bonds only because they had the phrase “Patriot Bonds” printed between your Social Security Number and date of issue.
I Savings Bonds
The I Savings Bond collect interest that gets compounded semi-annually, on the six month anniversary of their issuance. The interest is added to the bond’s principal value, meaning that they are enchanted by the magic of compounding interest. The interest rate is determined by a combination of:
- A fixed interest rate
- An inflation-based interest rate
In the late nineties and early 2000’s, the fixed
interest rates were pretty good – ranging from a high of 3.6% in May of 2000 to a low of 2.00% in May of 2002. In November of 2002, the fixed interest rate dropped to 1.6%, continued sliding towards zero until November of 2010, and that’s where the rate has rested ever since. We could see a fixed interest rate that’s greater than zero in May of 2013, but with the state of the global economy that’s just not likely.
The inflation-based interest rate varies every six months, and it applies to your bond regardless of when it was purchased. It is possible for this rate to be negative (if we were to have deflation), but that’s only ever happened once, in May of 2009.
The interest paid is based on the sum of both rates – so if you have a 0% fixed rate and a 1.5% inflation rate, you’ll earn 1.5%. If the sum of the two were to cause your interest rate to be less than zero (as was the case for most I bond holders in May of 2009) you won’t lose money – your rate will simply be zero.
EE Savings Bonds
These bonds are assigned a fixed interest rate at the time of purchase and that rate will never change for as long as you own the bond. Rates for newly purchased bonds are set on May 1 st and November 1 st of each year. This doesn’t apply to EE bonds purchased before May 1 st. 1997, though – they had variable interest rates, and that stays the same.
You can continue earning interest on an EE bond for a total of 30 years. At that point, the gravy train stops, and you’d be wise to cash out. Otherwise, your money is just sitting there, like a lazy slob (instead of working for you). You can cash your bond out at any time after owning it for one year, but if you haven’t owned it for at least five years, you’ll lose the last three months of interest.
Buying US Savings Bonds
All US Savings Bonds are currently sold through the TreasuryDirect.com website. They’re also tracked and managed digitally, too. There are no more “paper savings bonds.” I guess if you want something like that, you could always print up the details on your own fancy certificate.
Do Savings Bonds Have a Place in Your Portfolio?
This is a highly debatable question! Savings bonds definitely provide a secure investment, but the rate of return is usually negligible. They’re designed to be long-term investments, and if you pull your cash out too early, you won’t gain what you otherwise could have.
If you want to keep your funds liquid, you can earn similar interest rates with basic savings accounts (such as the Ally Bank High Yield Savings Account, which is earning 0.9% at the date of writing this article). The advantage, here, is that you have access to that cash as soon as you need it. It’s also backed by the FDIC, so it’s unlikely that you’ll lose your investment.
Savings bonds are a good way to help show kids how investing works, to an extent. If that’s your goal, you’re probably better off helping them set up a fantasy trading account and stashing their cash in a high-yield savings account.
I’m not a big fan of savings bonds, if you can’t tell. But I do realize that they have a place in some investor’s portfolios. Since they’re guaranteed and provide can provide a fixed-rate of return, they can help diversify your investments with a guaranteed rate of return for up to thirty years, and that’s definitely worth something.
Category: Personal Finance