How Do Savings Bonds Work?

how does a savings bond work

Individual savings bonds are low-risk, liquid savings vehicles that earn interest over time. If you want to start saving for your children or yourself and you are leery of the amount of risk associated with other financial investment vehicles, US savings bonds could be a great alternative. Sold and redeemed as a paper security, savings bonds can be redeemed at any time making them one of the most liquid savings vehicles available. That said, they do work a bit differently than traditional corporate or government bonds traded on an exchange. So just how do US Savings Bonds work?

How Does A Savings Bond Work?

There are two types of US savings bonds, EE series savings bonds and I series savings bonds, each slightly different from each other. They have some things in common, though. When an investor purchases a government-issued bond, they are technically investing in the government and the overall health of the economy. In return for lending money to the government, the investor will earn interest in their money just as with any other bond. Interest rates do change over time, which you can find directly on the website or at your local bank. Bonds begin earning interest upon purchase and most savings bonds will continue to earn interest until their end-of-life date. This period is currently 30 years for both EE and I savings bonds, however, both can be redeemed early (sometimes a penalty is involved, though). Also, both are currently sold at face value, meaning you pay $100 for a $100 paper bond certificate. This hasn’t always been the case.

Instead of just being insured by a government-backed agency like the FDIC (as with CDs or savings accounts. for example) they are issued directly by the US government itself, making them among the safest investments in existence.

Series I Savings Bonds

Series I Savings Bonds are, quite frankly, awesome. They work in much the same way as Treasury Inflation Protected Securities (or TIPS, an excellent inflation hedge ) do, except they have very attractive tax benefits and don’t trade on an exchange. Unfortunately, each individual is limited to buying $10,000

worth of I Bonds per year (meaning a couple could each buy $10,000 worth of I Bonds each year for a total of $20,000).

How The I Bond Interest Rate Is Determined

The unique thing about I Bonds is, like tips, they earn a combination two separate rates: a fixed “real” rate and an inflation rate. When you buy an I Bond with a 1% fixed “real” rate, you are basically guaranteed to earn 1% in excess of inflation until the bond matures. How does the Treasury accomplish this? By adjusting the inflation of the I Bond twice per year (announced in May and November). The inflation rate is added to the fixed rate to arrive at the total interest rate paid by the bond. While this rate is guaranteed to never be lower than 0%, it is possible for the composite rate to be less than the fixed “real” rate in deflationary environments. For example, if the fixed “real” rate is 1% but inflation runs at -0.5% (meaning prices fall) the composite rate would be only 0.5%. Remember, the fixed “real” rate is the rate after inflation, which can be negative. In practice, inflation typically runs in the 2-4% per year range so you’re looking at a pretty decent rate of return in the long run.

Favorable Tax Treatment Of I Bonds

I Bonds act like zero-coupon bonds in that you don’t actually receive regular interest payments. Instead, earned interest is automatically added to the principal of the bond. So if, for example, you own a $100 I Bond and the composite interest payment this year happens to be 3%, you would own a bond worth $103 at the end of the year. Why is this good? Because of the way the tax code works, you only pay taxes on interest payments when they are actually received. Since the interest is simply added to the I Bond’s principal, you don’t owe taxes on any of your earnings until you redeem your bond, which could be 30 years away. Deferring taxes in this way could save you thousands of dollars over a 30 year period.


Category: Personal Finance

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