So far in this group of posts on savings bonds we have covered the now defunct Series E bonds, the basics of Series EE Bonds, the basics of Series I Bonds, how to buy and sell savings bonds, two posts comparing Series EE savings bonds with Certificates of Deposit (CDs) and Treasury bills and notes and the first half of an analysis comparing Series I bonds to TIPs.[Link here]
Here’s the remainder of that discussion:
Rates of return: TIPs that mature in about five years currently yield 0.5%., a slightly higher return than the current 0.4% real interest rate on Series I savings bonds. If we increase the maturity to 10 years, the yield on TIPs rises to 1.2%—significantly higher than you get with the current Series I bond. At 20 years (actually closer to 18.5 years given the outstanding TIP issues) the TIP yield is up to almost 1.9%. That rate remains essentially flat for bonds up to the longest outstanding TIP (not quite 30 years).
Taxes: Taxation: How savings bonds interest is taxed has been discussed in previous posts.
Both the interest and increased principal from TIPs are taxed in the year earned. Every six months you will receive the interest payments but not the increase in principal. Consequently, you must pay taxes on the increased principal from other funds. Taxation of the earned, but not yet received, principal increase is one reason most people choose to own TIPs in their IRAs rather than in taxable accounts.
In the previous post I discussed the general advantages of deferring taxes, but in summary, although tax-deferral is an advantage of savings bonds, at today’s interest rates, and assuming constant tax rates, the effective rate of return on Treasuries is greater than Series I bonds and overwhelms the Series I tax-deferral advantage.
Conclusion: Again, there is no simple one-size-fits-all answer. Compared to TIPs, Series I bonds have three significant advantages: they are simpler to buy and redeem; you can buy them with as little as $25; in case of deflation, they provide more value than TIPs.
If you really think deflation is going to be the norm during the period you expect to hold your bond, then you should buy neither TIPs nor Series I bonds. Hie thee to the treasury market and buy a Treasury Strip of your desired duration.
Unless you are not planning to hold your purchase for a few years, the extra yield on TIPs seems to me to be worth the added aggravation (which isn’t much with TreasuryDirect®) of buying TIPs online provided (1) you can take accept the swings in market value TIPs endure, (2) you don’t plan on selling before maturity (or have the financial resources to handle a capital loss, and (3) you are purchasing at least $1,000 worth of securities.
~Jim
Friday, July 30, 2010
Wednesday, July 28, 2010
Plusses and Minuses of I Savings Bonds, Part I
So far in this group of posts on savings bonds we have covered the now defunct Series E bonds, the basics of Series EE Bonds, the basics of Series I Bonds, how to buy and sell savings bonds and two posts comparing Series EE savings bonds with Certificates of Deposit (CDs) and Treasury bills and notes.
The return on Series I bonds consists of a real interest rate, which is set at the date the bond is issued, and an inflation component, which depends on inflation over the bond’s life. Because of this inflation component, the closest alternative investment is the Treasury Inflation Protection bond (TIP) issued by the Federal Government.
In this post I will avoid repeating much detail from earlier posts when the comparison of Series I bonds and TIPs is the same as for Series EE bonds and Treasuries.
How Inflation is Recognized in the Bond: Before we make comparisons between Series I bonds and TIPs, it is useful to understand the differences in how inflation is recognized under each. With Series I bonds your interest rate is reset every six months equal to the initial real rate plus an inflation adjustment based on recent historical inflation. The key point for this discussion is that if deflation occurs for a period of time, the interest rate cannot be lower than the real rate. Because you always minimally earn the real interest rate, the value of your Series I bond is monotonically increasing (i.e. it never decreases, although it may stay constant for a period of time if your real rate is 0%).
TIPs are also issued with a real rate of return. TIPs, however, operate through a different mechanism: the principal amount reflects accumulated inflation since the bond’s issue. To determine the current principal amount, multiply the original principal amount by the ratio of the current CPI to the CPI at issue. Interest is paid every six-months determined as the real rate of return multiplied by the adjusted principal.
If the economy only experiences inflation (no deflation), these two mechanisms will produce very similar results assuming they started with the same real interest rate. The main difference is that Series I interest compounds, whereas TIP interest is paid out (and must be reinvested to compound.)
Deflation: The interest rate on Series I bonds cannot be decreased below the real interest rate. The principal on TIPs can be reduced below the original issue when used to determine the interest paid. Upon maturity, if the adjusted principal remains below the original principal, the bond pays the original principal, so no principal is lost due to deflation. However, the interest paid for any six-month period can be less than the real rate multiplied by the original principal.
To illustrate, assume both the Series I bond and the TIP have a real rate of return of 2%. Prior to their issue inflation has been steady at 0%. After six months the measured inflation has increased 5%. During the next six months the measured inflation is -10% (severe deflation). During the third six months inflation again roars ahead at +5%. These huge swings are not very realistic; they are designed to illustrate the differences between the two securities.
Series I bond:
$1000 face value.
After 6 months its value is $1,060.50
After 12 months its value is $1,071.10
After 18 months its value is $1,135.91
To make the comparison fair, we’ll assume interest is also compounded for the TIP. The value we are generating is equal to the adjusted principal plus accumulated interest.
TIP:
$1000 face value.
After 6 months its value is $1,060.00
After 12 months its value is $ 964.60
After 18 months its value is $1,022.48
I’m not going to claim these are the precise figures (because I have taken shortcuts on reinvesting interest payments for the TIP), but these approximations illustrate the value a Series I bond has by having a minimum interest rate applied to the accumulated bond value. Clearly, if deflation is going to occur while you are holding the bonds, the advantage goes to the Series I bonds (although standard Treasury bonds would probably do even better).
Default Risk: As with Series EE bonds, Series I bonds are issued by the Federal Government and the default risk is almost nonexistent.
Risk of Decreased Value Prior to Maturity: As previously discussed, the value of savings bonds is monotonically increasing.
TIPs pay interest twice a year and at maturity pay their adjusted principal value (but no less than the original principal). If you need to sell a TIP prior to maturity, it will be subject to market risk relative to both the real and inflation components of interest rates, as well as to whatever has already happened to the adjusted principal. There is a large secondary market in Treasuries, but you will have to pay broker costs to sell.
Call Protection: Neither Series I bonds nor TIPs are callable.
Interest Accrual Period: Series I bonds continue to accrue interest for 30 years. TIPs have maturity dates ranging up to 30 years.
Ease of Purchase: Series I bonds can be purchased directly from most financial institutions or online through TreasuryDirect®. Newly issued TIPs can also be purchased through TreasuryDirect®. You can also purchase previously issued TIPs through a broker.
Transaction Fees: There are no transaction fees to purchase or redeem savings bonds. If you buy Treasuries at auction through TreasuryDirect® there are no purchase fees. Similarly, if your TIP matures, there should be no transaction fee to surrender your security. However, if you sell a TIP before its maturity, you will be subject to broker fees.
Amount of Purchase: As discussed previously, the maximum annual purchase for each kind of savings bond (Series EE or Series I, paper or electronic) is $5,000. There are no maximum amounts for Treasuries.
All that remains to discuss is the rate of return on Series I bonds when compared to TIPs, which we’ll save for the next post.
The return on Series I bonds consists of a real interest rate, which is set at the date the bond is issued, and an inflation component, which depends on inflation over the bond’s life. Because of this inflation component, the closest alternative investment is the Treasury Inflation Protection bond (TIP) issued by the Federal Government.
In this post I will avoid repeating much detail from earlier posts when the comparison of Series I bonds and TIPs is the same as for Series EE bonds and Treasuries.
How Inflation is Recognized in the Bond: Before we make comparisons between Series I bonds and TIPs, it is useful to understand the differences in how inflation is recognized under each. With Series I bonds your interest rate is reset every six months equal to the initial real rate plus an inflation adjustment based on recent historical inflation. The key point for this discussion is that if deflation occurs for a period of time, the interest rate cannot be lower than the real rate. Because you always minimally earn the real interest rate, the value of your Series I bond is monotonically increasing (i.e. it never decreases, although it may stay constant for a period of time if your real rate is 0%).
TIPs are also issued with a real rate of return. TIPs, however, operate through a different mechanism: the principal amount reflects accumulated inflation since the bond’s issue. To determine the current principal amount, multiply the original principal amount by the ratio of the current CPI to the CPI at issue. Interest is paid every six-months determined as the real rate of return multiplied by the adjusted principal.
If the economy only experiences inflation (no deflation), these two mechanisms will produce very similar results assuming they started with the same real interest rate. The main difference is that Series I interest compounds, whereas TIP interest is paid out (and must be reinvested to compound.)
Deflation: The interest rate on Series I bonds cannot be decreased below the real interest rate. The principal on TIPs can be reduced below the original issue when used to determine the interest paid. Upon maturity, if the adjusted principal remains below the original principal, the bond pays the original principal, so no principal is lost due to deflation. However, the interest paid for any six-month period can be less than the real rate multiplied by the original principal.
To illustrate, assume both the Series I bond and the TIP have a real rate of return of 2%. Prior to their issue inflation has been steady at 0%. After six months the measured inflation has increased 5%. During the next six months the measured inflation is -10% (severe deflation). During the third six months inflation again roars ahead at +5%. These huge swings are not very realistic; they are designed to illustrate the differences between the two securities.
Series I bond:
$1000 face value.
After 6 months its value is $1,060.50
After 12 months its value is $1,071.10
After 18 months its value is $1,135.91
To make the comparison fair, we’ll assume interest is also compounded for the TIP. The value we are generating is equal to the adjusted principal plus accumulated interest.
TIP:
$1000 face value.
After 6 months its value is $1,060.00
After 12 months its value is $ 964.60
After 18 months its value is $1,022.48
I’m not going to claim these are the precise figures (because I have taken shortcuts on reinvesting interest payments for the TIP), but these approximations illustrate the value a Series I bond has by having a minimum interest rate applied to the accumulated bond value. Clearly, if deflation is going to occur while you are holding the bonds, the advantage goes to the Series I bonds (although standard Treasury bonds would probably do even better).
Default Risk: As with Series EE bonds, Series I bonds are issued by the Federal Government and the default risk is almost nonexistent.
Risk of Decreased Value Prior to Maturity: As previously discussed, the value of savings bonds is monotonically increasing.
TIPs pay interest twice a year and at maturity pay their adjusted principal value (but no less than the original principal). If you need to sell a TIP prior to maturity, it will be subject to market risk relative to both the real and inflation components of interest rates, as well as to whatever has already happened to the adjusted principal. There is a large secondary market in Treasuries, but you will have to pay broker costs to sell.
Call Protection: Neither Series I bonds nor TIPs are callable.
Interest Accrual Period: Series I bonds continue to accrue interest for 30 years. TIPs have maturity dates ranging up to 30 years.
Ease of Purchase: Series I bonds can be purchased directly from most financial institutions or online through TreasuryDirect®. Newly issued TIPs can also be purchased through TreasuryDirect®. You can also purchase previously issued TIPs through a broker.
Transaction Fees: There are no transaction fees to purchase or redeem savings bonds. If you buy Treasuries at auction through TreasuryDirect® there are no purchase fees. Similarly, if your TIP matures, there should be no transaction fee to surrender your security. However, if you sell a TIP before its maturity, you will be subject to broker fees.
Amount of Purchase: As discussed previously, the maximum annual purchase for each kind of savings bond (Series EE or Series I, paper or electronic) is $5,000. There are no maximum amounts for Treasuries.
All that remains to discuss is the rate of return on Series I bonds when compared to TIPs, which we’ll save for the next post.
Monday, July 26, 2010
Plusses and Minuses of EE Savings Bonds, Part II
This is the second of two parts on the plusses and minuses of EE savings bonds. The first part dealt with everything except after tax rates of return. Previous posts on savings bonds covered the now defunct Series E bonds, the basics of Series EE Bonds, the basics of Series I Bonds and how to buy and sell savings bonds.
Rates of return: In evaluating a Series EE bond’s rate of return, the major question you must answer is whether you for sure you will hold the Savings Bond for at least 20 years. If not, your rate of return on a bond bought today is 1.4%. If you do hold the bond and cash it out at exactly 20 years, your return hops up to 3.5%—a big difference.
Current CD rates for five years are running in the 2.2% –2.5% range—well over the 1.4% you can earn on an EE bond. The interest rate for ten-year CDs is a bit over 3%. While longer CDs are sometimes available, they usually come with call provisions attached and so are not strictly comparable.
Thus, compared to CDs, if you are going to hold the EE savings bond for ten years or less and are fairly confident you will not have to cash in the CD before it matures (or you buy it at a local bank that allows for cashing in the CD with a modest penalty) then a CD generally provides a better deal. Even, if you don’t plan to touch the money for 20 or 30 years, finding a CD to buy for the whole period will be difficult.
Not so with Treasuries, where we can find maturities up to 30 years. To make rate of return comparisons between EE savings bonds and Treasury securities more accurate, we’ll compare EE bonds with Treasury “strips.” Strips are treasury securities that have had the interest payments removed so they only pay the face value of the bond at maturity. Like a paper EE bond, they sell at a discount and pay off full value at maturity. The difference between the purchase price and face value is its return, which is equivalent to a savings bond’s accrued interest.
Strips that mature in about five years currently yield 1.6-1.8%., a slightly higher return than an EE savings bond held for the same period. If we increase the maturity to 10 years, the yield on Treasury strips rises to 3.1-3.3%—much higher than you get with the current EE bond. At 20 years the yield is 4.0-4.1%, still higher than the 3.5% return you receive from the EE bond.
Taxes: We can’t ignore taxes in this deal. Savings bonds and Treasuries are both taxed at the Federal level, but not by states or locally. Series EE bonds allow you to defer taxation on the interest earnings until you cash in the bond or at the end of 30 years when it matures and stops paying interest. Most people choose to defer taxes, but you can elect to pay taxes each year on the interest earned during the year. If you make this election, it must apply to all savings bonds you own.
Treasury strips do not allow you the option of postponing taxes. Each year you are taxed on the implied interest you have earned during the year. Since you do not receive any interest until the Treasury matures, you must pay the taxes from other sources.
If you think income taxes will increase, paying taxes earlier isn’t necessarily a bad deal, but otherwise you lose out in some of the compounding effects of tax-deferred returns (the reason traditional IRAs are preferable to holding money in a taxable account). However, given the current microscopic returns on bank accounts these days the benefit of deferring taxes (assuming constant tax rates) is fairly small.
In summary, tax effect is an advantage of savings bonds; but at today’s interest rates, and assuming constant tax rates, the effective rate of return on Treasuries is greater than Series EE bonds.
Conclusion: There is no simple one-size-fits-all answer. Compared to CDs and Treasuries, the main advantages Series EE bonds have are simplicity and that you can buy them with as little as $25. You can transact your business online or at a local financial institution and everything is relatively easy—which seems to be what Congress intended.
If you expect to hold the savings bond for only a few years, this simplicity might be worth enough to give up a few basis points of return relative to Treasuries. But buying a CD from your local bank isn’t very difficult and will pay better—just make sure you can cash in the CD early (with a prepayment penalty) should the need arise.
If you expect to hold the savings bonds for ten years or more, you are giving up a lot of return compared with buying Treasuries. Even if you don’t yet know enough to buy Treasuries on your own and have to pay a broker to help you buy and sell them, they still should provide much more value the Series EE bonds. The biggest caveat here is that with the extra return comes the extra risk if you must sell the Treasury before it matures and you become subject to market risk.
Next up: Plusses and Minuses of Series I Bonds.
~ Jim
Rates of return: In evaluating a Series EE bond’s rate of return, the major question you must answer is whether you for sure you will hold the Savings Bond for at least 20 years. If not, your rate of return on a bond bought today is 1.4%. If you do hold the bond and cash it out at exactly 20 years, your return hops up to 3.5%—a big difference.
Current CD rates for five years are running in the 2.2% –2.5% range—well over the 1.4% you can earn on an EE bond. The interest rate for ten-year CDs is a bit over 3%. While longer CDs are sometimes available, they usually come with call provisions attached and so are not strictly comparable.
Thus, compared to CDs, if you are going to hold the EE savings bond for ten years or less and are fairly confident you will not have to cash in the CD before it matures (or you buy it at a local bank that allows for cashing in the CD with a modest penalty) then a CD generally provides a better deal. Even, if you don’t plan to touch the money for 20 or 30 years, finding a CD to buy for the whole period will be difficult.
Not so with Treasuries, where we can find maturities up to 30 years. To make rate of return comparisons between EE savings bonds and Treasury securities more accurate, we’ll compare EE bonds with Treasury “strips.” Strips are treasury securities that have had the interest payments removed so they only pay the face value of the bond at maturity. Like a paper EE bond, they sell at a discount and pay off full value at maturity. The difference between the purchase price and face value is its return, which is equivalent to a savings bond’s accrued interest.
Strips that mature in about five years currently yield 1.6-1.8%., a slightly higher return than an EE savings bond held for the same period. If we increase the maturity to 10 years, the yield on Treasury strips rises to 3.1-3.3%—much higher than you get with the current EE bond. At 20 years the yield is 4.0-4.1%, still higher than the 3.5% return you receive from the EE bond.
Taxes: We can’t ignore taxes in this deal. Savings bonds and Treasuries are both taxed at the Federal level, but not by states or locally. Series EE bonds allow you to defer taxation on the interest earnings until you cash in the bond or at the end of 30 years when it matures and stops paying interest. Most people choose to defer taxes, but you can elect to pay taxes each year on the interest earned during the year. If you make this election, it must apply to all savings bonds you own.
Treasury strips do not allow you the option of postponing taxes. Each year you are taxed on the implied interest you have earned during the year. Since you do not receive any interest until the Treasury matures, you must pay the taxes from other sources.
If you think income taxes will increase, paying taxes earlier isn’t necessarily a bad deal, but otherwise you lose out in some of the compounding effects of tax-deferred returns (the reason traditional IRAs are preferable to holding money in a taxable account). However, given the current microscopic returns on bank accounts these days the benefit of deferring taxes (assuming constant tax rates) is fairly small.
In summary, tax effect is an advantage of savings bonds; but at today’s interest rates, and assuming constant tax rates, the effective rate of return on Treasuries is greater than Series EE bonds.
Conclusion: There is no simple one-size-fits-all answer. Compared to CDs and Treasuries, the main advantages Series EE bonds have are simplicity and that you can buy them with as little as $25. You can transact your business online or at a local financial institution and everything is relatively easy—which seems to be what Congress intended.
If you expect to hold the savings bond for only a few years, this simplicity might be worth enough to give up a few basis points of return relative to Treasuries. But buying a CD from your local bank isn’t very difficult and will pay better—just make sure you can cash in the CD early (with a prepayment penalty) should the need arise.
If you expect to hold the savings bonds for ten years or more, you are giving up a lot of return compared with buying Treasuries. Even if you don’t yet know enough to buy Treasuries on your own and have to pay a broker to help you buy and sell them, they still should provide much more value the Series EE bonds. The biggest caveat here is that with the extra return comes the extra risk if you must sell the Treasury before it matures and you become subject to market risk.
Next up: Plusses and Minuses of Series I Bonds.
~ Jim
Friday, July 23, 2010
Plusses and Minuses of EE Savings Bonds, Part I
So far in this group of posts on savings bonds we have covered the now defunct Series E bonds, the basics of Series EE Bonds, the basics of Series I Bonds and how to buy and sell savings bonds. Today we’ll compare Series EE savings bonds with Certificates of Deposit (CDs) and Treasury bills and notes.
Default Risk: Because Series EE savings bonds are issued by the Federal Government the risk of default is almost nonexistent (and if the Federal Government does default we’ve got a lot more problems than our savings bond holdings). CDs are insured by the FDIC up to specified limits, so as long as you stay under those limits, your CDs are insured by the Federal Government as well. Since the Federal Government issues Treasury bills and notes, they have the same risk of default.
Risk of Decreased Value Prior to Maturity: The value of savings bonds is monotonically increasing (i.e. it never decreases, although it may stay constant for a period of time). Savings bonds accumulate and compound interest. You get the interest when you cash the bond in. If you cash in a savings bond before maturity, you get its accumulated interest less any prepayment penalties. Remember, you cannot cash savings bonds in for the first year.
Some CDs allow you to reinvest the interest in the CD (the same as a savings bond); the rest pay out interest as it is earned. CDs typically pay out interest either monthly, quarterly or semi-annually. The value of a CD at maturity will equal its face value plus accrued interest. However, if you need to cash out a CD before its maturity, its value is subject to fluctuation.
Some CDs have prepayment penalties similar to those for savings bonds. For those, you receive the full value of your CD plus accumulated interest less the prepayment penalty. Other CDs, however, do not allow for prepayment except in the case of death, where a put option allows your estate to sell the CD back to the bank at full face value. To convert the CD to cash prior to maturity, you will have to sell the CD on the open market. If interest rates have risen since you bought the CD, its value will have fallen and you will suffer a loss. Conversely, if interest rates have declined, you may receive more than the face value of the CD. Regardless, if you must turn to the open market, you will have to pay a brokerage commission to sell your CD.
Treasury bills and notes generally pay interest twice a year. At maturity they pay their face value. If you need to sell them prior to maturity, you will be subject to market risk. As with CDs if interest rates have increased, you will sell at a loss. If interest rates have decreased you will sell with a gain. There is a large secondary market in Treasuries, but you will have to pay broker costs to sell.
Call Protection: Savings bonds are noncallable. You can decide when to cash them in; the government cannot force you to surrender them earlier than you wish. Some CDs are callable, which means if interest rates decline the issuer can force you to sell the CD back to them at a time when any reinvestment will be at lower interest rates.
Treasury securities are noncallable.
Interest Accrual Period: Savings bonds continue to accrue interest for 30 years. CDs and Treasuries stop earning interest after maturity, which for Treasuries can be up to 30 years. Most CDs have much shorter maturities, although you can usually find CDs with maturities of up to 20 years.
Taxation: Savings bonds interest earnings are not taxable by state and local governments, nor are interest earnings on Treasury securities. CD interest is, however, taxable by state and local governments. All three instruments are taxed by the Federal Government.
Under certain situations the proceeds from the sale of savings bonds can be applied to qualified educational expenses and be exempt from federal income taxes. No such benefit exists for CDs or Treasuries.
Ease of Purchase: CDs can be purchased directly from most financial institutions or online through TreasuryDirect®. Newly issued Treasury bills and notes can also be purchased through TreasuryDirect®. You can also purchase Treasuries through a broker.
Transaction Fees: There are no transaction fees to purchase or redeem savings bonds. If you buy Treasuries at auction through TreasuryDirect® there are no purchase fees. Similarly, if you purchase a newly issued CD, the bank picks up any transaction costs. If your Treasury or CD matures, there should be no transaction fee to surrender your security. However, if you sell either a CD or Treasury before its maturity, you will be subject to broker fees.
Amount of Purchase: The maximum annual purchase for each kind of savings bond (Series EE or Series I; paper or electronic) is $5,000. There are no maximum amounts for CDs or Treasuries. (Although to retain the FDIC guarantee for all of your CDs, you must keep the value of your CDs at any particular institution below the insurance limit.)
All that remains to discuss the rate of return on Series EE bonds when compared to CDs and Treasuries and the effect of taxation on the rate of return, which we’ll save for the next post.
~ Jim
Default Risk: Because Series EE savings bonds are issued by the Federal Government the risk of default is almost nonexistent (and if the Federal Government does default we’ve got a lot more problems than our savings bond holdings). CDs are insured by the FDIC up to specified limits, so as long as you stay under those limits, your CDs are insured by the Federal Government as well. Since the Federal Government issues Treasury bills and notes, they have the same risk of default.
Risk of Decreased Value Prior to Maturity: The value of savings bonds is monotonically increasing (i.e. it never decreases, although it may stay constant for a period of time). Savings bonds accumulate and compound interest. You get the interest when you cash the bond in. If you cash in a savings bond before maturity, you get its accumulated interest less any prepayment penalties. Remember, you cannot cash savings bonds in for the first year.
Some CDs allow you to reinvest the interest in the CD (the same as a savings bond); the rest pay out interest as it is earned. CDs typically pay out interest either monthly, quarterly or semi-annually. The value of a CD at maturity will equal its face value plus accrued interest. However, if you need to cash out a CD before its maturity, its value is subject to fluctuation.
Some CDs have prepayment penalties similar to those for savings bonds. For those, you receive the full value of your CD plus accumulated interest less the prepayment penalty. Other CDs, however, do not allow for prepayment except in the case of death, where a put option allows your estate to sell the CD back to the bank at full face value. To convert the CD to cash prior to maturity, you will have to sell the CD on the open market. If interest rates have risen since you bought the CD, its value will have fallen and you will suffer a loss. Conversely, if interest rates have declined, you may receive more than the face value of the CD. Regardless, if you must turn to the open market, you will have to pay a brokerage commission to sell your CD.
Treasury bills and notes generally pay interest twice a year. At maturity they pay their face value. If you need to sell them prior to maturity, you will be subject to market risk. As with CDs if interest rates have increased, you will sell at a loss. If interest rates have decreased you will sell with a gain. There is a large secondary market in Treasuries, but you will have to pay broker costs to sell.
Call Protection: Savings bonds are noncallable. You can decide when to cash them in; the government cannot force you to surrender them earlier than you wish. Some CDs are callable, which means if interest rates decline the issuer can force you to sell the CD back to them at a time when any reinvestment will be at lower interest rates.
Treasury securities are noncallable.
Interest Accrual Period: Savings bonds continue to accrue interest for 30 years. CDs and Treasuries stop earning interest after maturity, which for Treasuries can be up to 30 years. Most CDs have much shorter maturities, although you can usually find CDs with maturities of up to 20 years.
Taxation: Savings bonds interest earnings are not taxable by state and local governments, nor are interest earnings on Treasury securities. CD interest is, however, taxable by state and local governments. All three instruments are taxed by the Federal Government.
Under certain situations the proceeds from the sale of savings bonds can be applied to qualified educational expenses and be exempt from federal income taxes. No such benefit exists for CDs or Treasuries.
Ease of Purchase: CDs can be purchased directly from most financial institutions or online through TreasuryDirect®. Newly issued Treasury bills and notes can also be purchased through TreasuryDirect®. You can also purchase Treasuries through a broker.
Transaction Fees: There are no transaction fees to purchase or redeem savings bonds. If you buy Treasuries at auction through TreasuryDirect® there are no purchase fees. Similarly, if you purchase a newly issued CD, the bank picks up any transaction costs. If your Treasury or CD matures, there should be no transaction fee to surrender your security. However, if you sell either a CD or Treasury before its maturity, you will be subject to broker fees.
Amount of Purchase: The maximum annual purchase for each kind of savings bond (Series EE or Series I; paper or electronic) is $5,000. There are no maximum amounts for CDs or Treasuries. (Although to retain the FDIC guarantee for all of your CDs, you must keep the value of your CDs at any particular institution below the insurance limit.)
All that remains to discuss the rate of return on Series EE bonds when compared to CDs and Treasuries and the effect of taxation on the rate of return, which we’ll save for the next post.
~ Jim
Wednesday, July 21, 2010
Buying and Selling Savings Bonds
So far we have covered the now defunct Series E bonds, the basics of Series EE bonds and the basics of Series I bonds. Today we’ll discuss how to purchase and sell savings bonds.
There are two ways to purchase Series EE and Series I bonds: Paper & Electronic.
Electronic: The Federal Government has stated that its long-term goal is to consolidate all retail sales of Treasury Securities (of which Series EE and I bonds are a part) in TreasuryDirect®. To use TreasuryDirect® you first must have a savings or checking account at a bank that will allow direct transfers back and forth between it and the US Treasury.
Second, you must open a TreasuryDirect® account, which is an easy process.
Once your account is open you can make your purchase of either Series EE or Series I bonds in any amount between $25.00 and $5,000.00. See below for annual purchase limits.
The Treasury automatically credits interest to your electronic account and provides easy tools to keep track of your bonds and their value. When you choose to sell, you do it through TreasuryDirect® and your bank account automatically receives the funds.
If you change bank accounts after you purchase the bonds and before you cash them out, it is a straightforward proposition to change the bank account linked to your TreasuryDirect® account.
Paper: You can buy paper bonds at most financial institutions. Series I bonds come in $50, $75, $100, $200, $500, $1,000 & $5,000 denominations and sell at face value. Series EE bonds come in $50, $75, $100, $200, $500, $1,000, $5,000 & $10,000 denominations, but sell at half the price. This is a holdover from the original Series E bonds that sold at a discount from the face value.
Using Employer Payroll Savings Plans: Rather than go into details here, you can check with your employer’s Human Resources department to see if they participate and what rules they have in place. The Treasury department is phasing out purchase of paper (as opposed to electronic) bonds. Effective 9/30/2010 federal government employees will no longer be able to purchase paper bonds through payroll deduction. The ban will extend to all employers effective 1/1/2011.
Annual Purchase Limits: An individual can buy up to $5,000 of each type and form of savings bond. So you can buy $5,000 electronic EE bonds, $5,000 paper EE bonds, $5,000 electronic Series I bonds and $5,000 paper Series I bonds. Why, since the government wants to convert everything to electronic form, they limit the amount to $5,000 of each type of bond but let you buy another $5,000 in paper form makes no sense to me – but them’s the rules.
Sales: You perform electronic sales through TreasuryDirect® and the Treasury deposits the proceeds directly in your linked savings or checking account. You can cash in paper certificates at many financial institutions and receive the proceeds in cash. Check ahead of time, however, since some banks have been known to delay payment until they send the bonds to the Federal Reserve and have received confirmation. Remember the restrictions we discussed in a previous article: except in the case of certain declared emergencies you will not be able to cash out a Series EE or I bond for 12 months after purchase. If you cash out within the first five years, you will lose three months’ interest.
Next Up: Plusses and Minuses of Savings Bonds.
~ Jim
There are two ways to purchase Series EE and Series I bonds: Paper & Electronic.
Electronic: The Federal Government has stated that its long-term goal is to consolidate all retail sales of Treasury Securities (of which Series EE and I bonds are a part) in TreasuryDirect®. To use TreasuryDirect® you first must have a savings or checking account at a bank that will allow direct transfers back and forth between it and the US Treasury.
Second, you must open a TreasuryDirect® account, which is an easy process.
Once your account is open you can make your purchase of either Series EE or Series I bonds in any amount between $25.00 and $5,000.00. See below for annual purchase limits.
The Treasury automatically credits interest to your electronic account and provides easy tools to keep track of your bonds and their value. When you choose to sell, you do it through TreasuryDirect® and your bank account automatically receives the funds.
If you change bank accounts after you purchase the bonds and before you cash them out, it is a straightforward proposition to change the bank account linked to your TreasuryDirect® account.
Paper: You can buy paper bonds at most financial institutions. Series I bonds come in $50, $75, $100, $200, $500, $1,000 & $5,000 denominations and sell at face value. Series EE bonds come in $50, $75, $100, $200, $500, $1,000, $5,000 & $10,000 denominations, but sell at half the price. This is a holdover from the original Series E bonds that sold at a discount from the face value.
Using Employer Payroll Savings Plans: Rather than go into details here, you can check with your employer’s Human Resources department to see if they participate and what rules they have in place. The Treasury department is phasing out purchase of paper (as opposed to electronic) bonds. Effective 9/30/2010 federal government employees will no longer be able to purchase paper bonds through payroll deduction. The ban will extend to all employers effective 1/1/2011.
Annual Purchase Limits: An individual can buy up to $5,000 of each type and form of savings bond. So you can buy $5,000 electronic EE bonds, $5,000 paper EE bonds, $5,000 electronic Series I bonds and $5,000 paper Series I bonds. Why, since the government wants to convert everything to electronic form, they limit the amount to $5,000 of each type of bond but let you buy another $5,000 in paper form makes no sense to me – but them’s the rules.
Sales: You perform electronic sales through TreasuryDirect® and the Treasury deposits the proceeds directly in your linked savings or checking account. You can cash in paper certificates at many financial institutions and receive the proceeds in cash. Check ahead of time, however, since some banks have been known to delay payment until they send the bonds to the Federal Reserve and have received confirmation. Remember the restrictions we discussed in a previous article: except in the case of certain declared emergencies you will not be able to cash out a Series EE or I bond for 12 months after purchase. If you cash out within the first five years, you will lose three months’ interest.
Next Up: Plusses and Minuses of Savings Bonds.
~ Jim
Monday, July 19, 2010
Series I Savings Bonds
As I noted in my last post, savings bonds have wrinkles that are important to understand to get the most out of owning them. As of today (7/19/2010) the federal government is issuing two kinds of savings bonds: Series EE and Series I. Today we’ll discuss the basics of the Series I savings bond. We’ll make several references to the previous post on Series E bonds [LINK], so if you haven’t read it, you might want to check it our first.
Series I bonds were first introduced in September 1998. Like Series EE bonds, they can earn interest for thirty years, and also like Series EE bonds you can’t cash them in for the first 12 months after purchase. If you cash them in within the first five years, you lose three months of interest. Unlike Series EE bonds, the interest rate is not the same each month.
Two components make up the interest rate on a Series I bond: a fixed rate that is set at the sale date remains throughout its life, and an inflation rate (which is why the bond is called the Series I.) The fixed rates are changed each May and November for bonds sold for the next six months. The graph below shows the rates since the bond’s inception. The maximum fixed rate was 3.6%; the minimum is 0.0%.
The inflation rate is calculated in May and November based on six-month changes in the CPI-U index. This semiannual inflation rate is combined with the fixed rate using the formula:
Total Rate = Fixed Rate + 2 x Inflation Rate + Fixed Rate x Inflation Rate.
For example, if the Fixed Rate = 1% and the semi-annual Inflation Rate = 1.4%, the total rate would be:
0.01 + 2 x 0.014 + 0.01 x 0.014 =
0.01 + 0.028 + 0.00014 =
0.03814 =
3.81%
When the inflation rate is less than zero, the calculation is performed as described above, but the final result cannot be less than 0.00%. In other words, you never lose any interest you have previously earned, even in the case of severe deflation.
Tax Advantages. The tax advantages are the same as for Series EE bonds.
In the next post we’ll talk about the ways you can buy and redeem EE and I Bonds. In the final post of this series I will also provide my thoughts about when the bonds might be good to include as part of your portfolio.
Next Up: How to Purchase and Redeem Savings Bonds.
~ Jim
Series I bonds were first introduced in September 1998. Like Series EE bonds, they can earn interest for thirty years, and also like Series EE bonds you can’t cash them in for the first 12 months after purchase. If you cash them in within the first five years, you lose three months of interest. Unlike Series EE bonds, the interest rate is not the same each month.
Two components make up the interest rate on a Series I bond: a fixed rate that is set at the sale date remains throughout its life, and an inflation rate (which is why the bond is called the Series I.) The fixed rates are changed each May and November for bonds sold for the next six months. The graph below shows the rates since the bond’s inception. The maximum fixed rate was 3.6%; the minimum is 0.0%.
The inflation rate is calculated in May and November based on six-month changes in the CPI-U index. This semiannual inflation rate is combined with the fixed rate using the formula:
Total Rate = Fixed Rate + 2 x Inflation Rate + Fixed Rate x Inflation Rate.
For example, if the Fixed Rate = 1% and the semi-annual Inflation Rate = 1.4%, the total rate would be:
0.01 + 2 x 0.014 + 0.01 x 0.014 =
0.01 + 0.028 + 0.00014 =
0.03814 =
3.81%
When the inflation rate is less than zero, the calculation is performed as described above, but the final result cannot be less than 0.00%. In other words, you never lose any interest you have previously earned, even in the case of severe deflation.
Tax Advantages. The tax advantages are the same as for Series EE bonds.
In the next post we’ll talk about the ways you can buy and redeem EE and I Bonds. In the final post of this series I will also provide my thoughts about when the bonds might be good to include as part of your portfolio.
Next Up: How to Purchase and Redeem Savings Bonds.
~ Jim
Friday, July 16, 2010
Series EE Savings Bonds
Once upon a time savings bonds were easy to understand. Now they have some wrinkles that are important to understand to get the most out of owning them. As of today (7/16/2010) the federal government is issuing two kinds of savings bonds: Series EE and Series I. Today we’ll discuss the basics of the current version of the Series EE savings bond.
Congress periodically fiddles with the savings bond rules, and the most recent big change was effective in 2005. Starting in May of that year, the interest rate on an EE savings bond is fixed for the next 20 years based on the rate in effect at its sale date. After 20 years the savings bond is considered “matured” but continues to earn interest at a rate that is set once the 20-year period has concluded based on then current rates. The initial rate for Series EE bonds is set twice a year, in May and November. The current rate for the first 20 years is 1.40% per annum, compounded semiannually.
The biggest wrinkle occurs at the end of the 20th year. When the fixed interest rate is less than 3.5%, at the 20th anniversary the value of the savings bond is increased to exactly twice its purchase price. At the current level of interest rates this wrinkle provides a big increase in value.
A microsecond before the 20th year is complete an EE savings bond bought today has increased a little over 32% in value. A fraction of a second later the increase changes to 100%. Talk about a wonky investment – don’t you wonder what Congress was smoking the day they decided this was a good idea?
The EE bond has some other wrinkles if you want to cash it in early. You are not allowed to cash in the bond until a year has passed. If you cash the bond during years two through five, you lose the last three months of interest.
Tax Advantages. The interest on Series EE bonds is not subject to state and local income taxes. For federal taxes, the interest can be deferred until the year the bond is cashed in or finally matures (30 years after its issue), whichever comes earlier. If you elect, you may pay income taxes on the interest as it is earned, but only if you make a special election and the election applies to all your savings bonds.
If you paid for higher-education expenses in the same year you cash in the bond (and meet a bunch of requirements beyond the scope of this blog entry) you can altogether exclude the Series EE bond income from your federal income tax calculations.
I’ll talk about the ways you can buy and redeem EE and I Bonds in a later post. I will also provide my thoughts about when the bonds might be good to include as part of your portfolio. First we need to cover the basics of the other savings bond.
Next Up: Series I Savings Bonds.
~ Jim
Congress periodically fiddles with the savings bond rules, and the most recent big change was effective in 2005. Starting in May of that year, the interest rate on an EE savings bond is fixed for the next 20 years based on the rate in effect at its sale date. After 20 years the savings bond is considered “matured” but continues to earn interest at a rate that is set once the 20-year period has concluded based on then current rates. The initial rate for Series EE bonds is set twice a year, in May and November. The current rate for the first 20 years is 1.40% per annum, compounded semiannually.
The biggest wrinkle occurs at the end of the 20th year. When the fixed interest rate is less than 3.5%, at the 20th anniversary the value of the savings bond is increased to exactly twice its purchase price. At the current level of interest rates this wrinkle provides a big increase in value.
A microsecond before the 20th year is complete an EE savings bond bought today has increased a little over 32% in value. A fraction of a second later the increase changes to 100%. Talk about a wonky investment – don’t you wonder what Congress was smoking the day they decided this was a good idea?
The EE bond has some other wrinkles if you want to cash it in early. You are not allowed to cash in the bond until a year has passed. If you cash the bond during years two through five, you lose the last three months of interest.
Tax Advantages. The interest on Series EE bonds is not subject to state and local income taxes. For federal taxes, the interest can be deferred until the year the bond is cashed in or finally matures (30 years after its issue), whichever comes earlier. If you elect, you may pay income taxes on the interest as it is earned, but only if you make a special election and the election applies to all your savings bonds.
If you paid for higher-education expenses in the same year you cash in the bond (and meet a bunch of requirements beyond the scope of this blog entry) you can altogether exclude the Series EE bond income from your federal income tax calculations.
I’ll talk about the ways you can buy and redeem EE and I Bonds in a later post. I will also provide my thoughts about when the bonds might be good to include as part of your portfolio. First we need to cover the basics of the other savings bond.
Next Up: Series I Savings Bonds.
~ Jim
Wednesday, July 14, 2010
Savings Bonds – Series E is now officially dead.
Someplace or the other while I was on vacation for three weeks touring the Canadian Maritimes I caught note that the last Series E bond has stopped paying interest. (The vacation explains the hiatus of posts.) Series E bonds earned interest for thirty years and the last one was issued in June 1980. As of July 1, 2010 no Series E bonds are earning interest and since interest has stopped accumulating, any deferred income is now taxable regardless of whether you cash them in or not.
From a decades old memory I can picture my father mentioning that he had unearthed some Savings Bonds he bought during World War II only to discover they had stopped paying interest sometime in the past. Don’t be like him in this regard. Unless your tax advisor has a particular reason why you should hold onto these bonds, cash them in and, at a minimum, earn the pittance current money markets or bank accounts are paying. Furthermore, if you have a bunch of Series E bonds, it might be a good time to consider rebalancing your portfolio.
Savings Bonds and I go back a long way. Thankfully, my parents taught me saving from an early age. A portion of any money I earned went to buying Series E savings bonds. In a time when stores competed for business by giving bonus S & H Green Stamps you could redeem for catalog merchandise, you could buy Savings Bond stamps at twenty-five cents a pop and paste them into a Savings Bond book. When you had $18.75 of stamps you could cash the book in at your local bank for a Series E Savings Bond.
From a finance standpoint I would have been better off keeping all those twenty-five cents in a bank account earning interest until I accumulated the $18.75 rather than buy the Savings Bond on the installment plan, but at age twelve I didn’t understand the time-value-of-money concept.
Today we have two types of Savings Bonds available, Series EE and Series I. In the next few blogs I’ll discuss each type of bond and whether they make sense as a part of your portfolio.
Next up: Series EE Savings Bonds.
~ Jim
From a decades old memory I can picture my father mentioning that he had unearthed some Savings Bonds he bought during World War II only to discover they had stopped paying interest sometime in the past. Don’t be like him in this regard. Unless your tax advisor has a particular reason why you should hold onto these bonds, cash them in and, at a minimum, earn the pittance current money markets or bank accounts are paying. Furthermore, if you have a bunch of Series E bonds, it might be a good time to consider rebalancing your portfolio.
Savings Bonds and I go back a long way. Thankfully, my parents taught me saving from an early age. A portion of any money I earned went to buying Series E savings bonds. In a time when stores competed for business by giving bonus S & H Green Stamps you could redeem for catalog merchandise, you could buy Savings Bond stamps at twenty-five cents a pop and paste them into a Savings Bond book. When you had $18.75 of stamps you could cash the book in at your local bank for a Series E Savings Bond.
From a finance standpoint I would have been better off keeping all those twenty-five cents in a bank account earning interest until I accumulated the $18.75 rather than buy the Savings Bond on the installment plan, but at age twelve I didn’t understand the time-value-of-money concept.
Today we have two types of Savings Bonds available, Series EE and Series I. In the next few blogs I’ll discuss each type of bond and whether they make sense as a part of your portfolio.
Next up: Series EE Savings Bonds.
~ Jim
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