Savings Bonds

I want to talk a little about savings bonds, since they seem like a comparatively good deal right now. Series EE savings bonds pay a fixed rate of interest, and Series I bonds pay a spread over inflation, as measured by the CPI. Of course, both of these rates are practically non-existent right now. The thing about them that’s interesting to me is some of the other provisions associated with them.

First, Series I, since, shockingly, that’s simpler. Right now, they pay the inflation rate. So, you’re guaranteed to lose money in real terms, once you take income taxes into account. But, it’s not as bad as you think, since the taxes are deferred until you cash the bond. You can cash them any time after the first year (though there’s a penalty of three months’ inflation if you cash them in the first five years). Why would you want a bond that was guaranteed to lose you money in real terms? Most of us have that sort of bond anyway: cash. So, if you’re keeping an emergency fund of several months’ living expenses lying around and not touching it barring some unforeseen calamity, you might as well try to earn as much as you can on it while keeping it perfectly liquid. Because savings bonds are guaranteed by the Treasury never to lose nominal value, unlike other bonds, if real interest rates go up, as they almost certainly must someday, you’re still protected. And what other essentially cash account is paying 1.96 percent these days?

I’m not suggesting anything, much less that anyone immediately go out and convert their entire cash cushion to I bonds. That would be nuts. But I have been slowly moving some of it out of a savings account and into these bonds. Gradually, since I’m not one to bet big on such a minor gain.

Series EE savings bonds are more interesting. As of this writing, they’re paying 0.1% interest. This is nothing. However, if they’re held for 20 years, they will double in value over the initial price because of a catch-up payment from the Treasury. That’s an IRR of 3.5%.1 Again, it’s tax-deferred, so you actually do get to keep that 3.5% compounding rate. Let’s compare to a 20 year T bond. As of last Friday, those were yielding 2.58%. So, that’s comparatively nice.

If you were able to reinvest at a higher rate, you could use the coupons from the tradable bond to buy better yielding bonds in the future. But, this would also push the value of that first bond down. Which brings us to another factor in favor of EE savings bonds. They have a built-in put. They can be cashed for, essentially, their purchase price2 at any time after the first year. If rates normalize in the near- to medium-term, there’s no loss of nominal capital: simply cash the bond and get a new one with a better interest rate. Given that the 3.5% IRR is higher than the yield on a “regular” 20 year bond, and given that there’s a put that comes with the bond, it seems like Series EE bonds are a pretty good deal as long as I’m willing to bet one of two things happens: rates stay low for 20 years or rates go back to normal some time in the next 10 years. If rates stay low for a long time but then normalize after 15 years, or, if there’s very strong inflation in year 17, for example, that would be unfortunate, but I don’t think I’d be much worse off compared to buying and holding a bond fund.

Let’s also talk briefly about costs. There are no expenses or commissions. I can buy savings bonds directly from the U.S. government online and cash them out the same way, with direct deposit into any bank account. Which I think is pretty convenient.

I’m interested in hearing what other people think about this, since, far from giving anyone financial advice, I’m much more interested in getting some myself.

  1. Or, for a quick check, \(\frac{72}{20} \approx 3.6\%\). [return]
  2. Technically, they do earn that 0.1% interest rate if they’re not held for 20 years, but who cares? [return]