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Investing/Strategies / Bonds & Fixed Income Investments
|Subject: Bond and F-I FAQs: Part 2 B||Date: 2/14/2007 2:20 PM|
|Author: Lokicious||Number: 19766 of 35790|
US Savings Bonds
What Types of Savings Bonds Are There?
• There are 2 series of US Savings Bonds that can currently be purchased: Series EE and Series I.
• Series I bonds are bought at face value.
• Series EE bonds are bought for half of face value.
---The face value of a Series EE bond is the guaranteed value that bond will reach by its original maturity date. Thus, if you hold an EE bond up to its original maturity date, you know exactly how much it will be worth (twice what you paid for it).
---The guaranteed face value does not limit the possible face value—it is simply a minimum face value guarantee.
• New EE bonds earn a fixed rate of interest for as long as you hold them (although the fine print says this rate is subject to change after the original maturity period, currently 20 years).
---For more information, see the Treasury's FAQ for fixed rate EE bonds and their link on maturity periods: http://www.treasurydirect.gov/indiv/research/indepth/eefixedratefaqs.htm http://www.publicdebt.treas.gov/sav/savmat.htm
• EE bonds purchased between May 1997 and May 2005 earn a variable rate that is reset every 6 months. They are no longer available for purchase.
---The interest rate is based on 90% of the average yield on 5-year Treasuries over the preceding 6 months.
---These EE bonds are also guaranteed to at least double in value by the original maturity date. If the interest accrued does not double the value of the EE bond by the maturity date, the Treasury makes a one-time adjustment to increase the bond's value to the face value at that time.
---However, because the interest rate is variable, their actual value at the original maturity date could be considerably more than double.
---For more information, see the Treasury's FAQ for variable rate EEs: http://www.publicdebt.treas.gov/sav/savrtfaq.htm
---For more information on EE bonds of both types, see: http://www.publicdebt.treas.gov/sav/savinvst.htm
---If you are holding Series E bonds that were purchased prior to May 1997, different rules apply. See the following links: http://www.publicdebt.treas.gov/sav/savnewee.htm http://www.publicdebt.treas.gov/sav/savoldee.htm
• I-Bonds are more complex than EE-Bonds. Their interest rate has 2 components:
---1) A fixed rate that is set when the bond is purchased, and remains fixed for the life of the bond;
---2) A variable rate that is set every 6 months, based upon the CPI-U (Consumer Price Index) for the preceding 6 months.
• Look here for a more detailed explanation (including the exact formula used to determine the composite rate each 6 months): http://www.publicdebt.treas.gov/sav/sbirate2.htm
---For more information, see the Treasury's I Bond FAQ: http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_i_faq.htm
• Although it has not yet happened, it is possible the CPI-U could be negative (deflation) for a 6-month period.
---In this case, the composite rate (the total interest rate earned) will become less than the I-Bond's fixed rate. However, the composite rate can never be less than 0%, so nothing will ever be lost from your previous earnings. This is a key difference between I Bonds and TIPS; see this post for an example: http://boards.fool.com/Message.asp?mid=17918368
• Through the years, the Treasury has sold many series of Savings bonds that are no longer available.
---Here's a link to learn more about any of the older savings bonds (except HH): http://www.treasurydirect.gov/indiv/research/indepth/other/othersecurities.htm
----Here's the link for HH Bonds: http://www.treasurydirect.gov/indiv/research/indepth/hbonds/res_hbonds.htm
Which Are Better, I-Bonds or EE-Bonds?
• Over any short period, one type of Savings Bond will almost certainly win out and, sometimes, when inflation surges, I-Bonds can be a good short-term savings device, even with the loss of 3-months interest.
---Unfortunately, many people look at the latest composite number on I-Bonds and expect that rate to continue.
---What really matters, long term (and these normally are long term savings devices), is the fixed rate.
• The question is whether or not the inflation adjustment component of I-Bonds will be enough, over time, to make up for their lower fixed rate, compared to the fixed-rate of new EE-bonds or 90% of the average yield on 5-year Treasuries for adjustable-rate EE-bonds.
---With the new fixed rate EE-Bonds, simply look at the current difference between the fixed rates. Using the 1% fixed rate on Series I versus 3.5% on Series EE, November 2005, for an example, the CPI-U adjustments would have to average more than 2.5% as long as you held them for I-Bonds to do better than EE-bonds.
---We don't know what CPI-U numbers will be in the future. Historical averages depend on what dates are used. (From 1914 through 2005, the average inflation rate was 3.43, but it was below 3% starting from 1921. 3% is a conventional guess, although the Federal Reserve is considering a target, probably in the 2-2.5% range.)
---Here are some links on historical inflation numbers: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt http://inflationdata.com/Inflation/Inflation_Rate/HistoricalInflation.aspx http://boards.fool.com/Message.asp?mid=23218393
• With the older EE-bonds, pegged at 90% 5-year Treasuries, our best guide is history, though there is no guarantee the future will repeat the past, even over the long term.
---Historically, 90% EE-Bonds would have beaten inflation by 2.25%-2.5% on the average (depending on dates used).
How Do Savings Bonds Compare to CDs, Treasuries, or TIPS?
• Here are some advantages of Savings Bonds:
---They are exempt from state and local taxes, especially important if your state and local tax rates are high. (This only applies in comparison to CDs, since Treasuries are also exempt from state and local taxes.)
---If you choose, you may delay/defer federal tax payment until the time you cash them in, unlike CDs, Treasuries, and TIPS where you must pay taxes on interest (and inflation adjustment) every year.
---If used for Higher Education (your own or your child's), interest on Savings Bonds may be tax free, with limits on Adjusted Gross income to qualify
---For more information on taxes, see http://www.treasurydirect.gov/indiv/research/indepth/ebonds/res_e_bonds_eetaxconsider.htm
---If you are currently taxed at a high marginal rate (federal, states with graduated income taxes), you may pay significantly lower taxes if your marginal rate is lower when you cash them in (e.g., after retirement). (If you are in the same tax bracket when you cash in a Savings Bond, as while you were holding it, the only advantage you get is a compounding effect from not paying taxes until the end).
---After 5 years, Savings Bonds are fully liquid and can be kept (for up to 30 years) or cashed in with no penalty. (They may not be cashed in for the first year, and there is a 3-month interest penalty applied up to 5 years.)
---You can buy Savings Bonds in small amounts (denominations), currently as little as $50 for I-bonds and $25 for EE-bonds, which make them a viable alternative to passbook savings for people with little cash to plunk down at one time, as well as a favorite choice for gifts. http://www.publicdebt.treas.gov/sav/savseree.htm http://www.publicdebt.treas.gov/sav/sbidenom.htm
• The principal disadvantage to US Savings Bonds is they pay much less interest than CDs, Treasuries, and TIPS.
---For most of those who can buy in the amounts required for CDs and Treasuries/TIPS (with the exception of people in high federal and state brackets expecting to be in lower brackets after retirement), the tax savings will not make up for the differences in yield, given the current fixed-rate EE or I-bonds.
---With the variable-rate EE-Bonds, pegged at 90% 5-year Treasuries, it was possible to make some exact calculations as to what it would take for EE-Bonds to win thanks to the tax delay advantage. If you dropped from a 25% bracket to a 15% bracket, EE-Bonds beat the Treasuries in as little a 5 years, despite the lower yield. If you stayed in the same tax bracket when you cashed in, it took between 18 and 25 years (depending on bracket) for the compounding effect to make EE-Bonds the winner.
---Comparing new fixed-rate EE-bonds and I-bonds to Treasuries and TIPS is guesswork (you will have new rates when you roll Treasuries or TIPS over, while you get the same rate on Savings Bonds). An educated guess would be that with a difference in yield of less than .5% (e.g., I-bond 1.5%, TIPS 1.9%), a significant drop in tax bracket should make the Savings Bond the better choice and, with more than 20 years to compound, Savings Bonds should win for that reason as well. If the yield difference reaches .8% to 1%, no tax-delay advantage will ever make up for the lower yield (with the possible exception noted above).