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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Bond and F-I FAQS Part 2: Savings Instruments Date: 1/16/2006 2:37 PM
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So, Like Maybe the Best Thing Is Just to Dump My Dough in the Bank?
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----Maybe. If you ignore the hype from the usual suspects, banks and credit unions do have good options for principal preserving investing. Thanks to the Internet, we now have access to a wide variety of banks, which forces them to be more competitive. Also, this makes it easier to use more than one bank or credit union if you have more money you want to put into savings than is protected by FDIC/NCUA in a single institution. Banks and Credit Unions, typically, pay higher interest on Money Market accounts than brokerages (which also are not FDIC protected) and, other than CDs, assets kept at banks, tend to be very liquid.
----FDIC and NCUA insurance is limited to $100,000 per individual account per bank/Credit Union. You may have different individual accounts at the same bank/CU if you have an IRA and/or a Roth IRA at the bank/CU in addition to a taxable account. Joint accounts are insured up to $200,000, and a couple may hold individual accounts (with spouse as beneficiary) plus a joint account (or joint accounts) at the same institution and get up to $400,000 worth of insurance. http://webapps.ncua.gov/Ins/InsuredFunds/NCUSIFInsJointIndACCT.htm#TwoJoint

Savings Accounts and Money Markets Sound Boring and Get Lousy Returns, Why Would I Want to Put Money in One of Those?

-----There was a time, well within the memory of those over age 50, that all that banks had to offer were Passbook Savings and Checking accounts. Savings accounts paid very little interest (you had to pay for checking), but you could move the money in and out easily by going to the bank and making deposits or withdrawals (including to keep your checks from bouncing). Anyone wanting higher interest from fixed income investments would have to buy US Savings bonds, or maybe Treasuries, though that was difficult for the average American.
-----Money Markets, which became common in the late 1970s (when inflation and interest rates were soaring), changed all that, along with automatic bank machines. Money markets paid much higher interest than savings accounts, generally in line with the yields of short term Treasuries. Typically, they allowed for the writing of a few big checks a month on the account, but otherwise limited transactions (e.g., not allowing the use of automatic bank machines, thus requiring a trip to the bank during banking hours), which kept banking costs down. They also had large minimum balances, again keeping down expenses for a given amount of deposit at the bank. So, for anyone able to keep minimum deposits on hand, money markets replaced savings accounts as the basic place to keep savings. (Over time, money markets have evolved into various hybrids, some banks and credit unions offering more than one option.)
-----Recently, Savings Accounts have seen a renaissance, thanks to on-line banking. These savings accounts have offered competitive interest compared to money markets, basically by having lower costs than brick and mortar banks and by having a long lag time transferring money.
----Some on-line Savings Accounts have high minimum balances. Others have low minimums or no minimums at all, while still paying much higher interest than has been typical from traditional Passbook Savings Accounts, often the only option available to those with less than $1000 to keep in savings.
-----Brokerages usually use money markets as the transit point for money going into and out of other investments. Typically, the interest paid by brokerage money markets is less than at banks and credit unions and is not FDIC or NCUA insured. In other words, brokerage money markets are a bad place to store money for any use except moving around assets held at the brokerage.
-----Both insured money markets and savings accounts keep your principal safe and pay interest, though the interest will generally be less than what can be had in a 2-year CD or Treasury or from US Savings Bonds (EE-, I-bonds). However, Money Markets and Savings Accounts are much more liquid—you don't have to pay early withdrawal penalties and you can have access to the money quickly (though exactly how varies).
-----Choosing which bank or credit union to use and which is preferable, a money market or a savings account, will depend on where you can get the best rate, convenience, and what kind of liquidity you want. If you are only keeping small amounts of money in the account for ongoing expenses and run-of-the-mill “emergencies” (the plumber, the unscheduled car repair), the convenience of a local brick and mortar bank or credit union still probably wins. However, some people argue that using credit cards and paying off the balance at the end of the month allows for the same convenience and liquidity, while letting you seek the highest interest rate.
-----For those wanting to keep substantial amounts of money in an account where the principal needs to be kept safe, the exact moment when the money is needed is uncertain, and money is gradually being accumulated—saving for a big-ticket item or down-payment for a house are good examples—seeking a slightly higher interest rate with less convenience and liquidity probably is the better choice.
-----For long term principal-preserving uses, notably emergency/contingency funds or “safe” retirement money, over time US Savings Bonds and/or a ladder of CDs that at worst have a small interest penalty, will do better than money markets or savings accounts.
-----A good source for banks and credit union rates (not everything is listed) is bankrate.com. Eligibility for joining credit unions is restricted, though looser than it was, so it may be possible to join a credit union with good rates through the back door (for a while the Pentagon Federal Credit Union had the best CD rates and was trying to find any possible angle to allow people to join).
http://www.bankrate.com/yho/compare_rates_home.asp
Credit Union Rates
http://www.bankrate.com/yho/rate/brm_cucdepsearch.asp?product=15

Okay, So Savings Accounts and Money Markets Are High on Liquidity and Low on Interest, What about CDs?

----CDs (Certificates of Deposit) are savings devices, generally issued by banks and credit unions (though now also made available through other institutions) that are intended for longer savings periods than more liquid bank vehicles, such as money markets, checking, and savings accounts.
----CDs are issued with different maturities, typically ranging from 3 months to 5 years (some 10-year CDs do exist), usually paying a higher interest rate for longer maturities.
----CDs typically have minimum amounts ($1000 is common), may pay a higher interest rate for very large amounts (e.g., $100,000), a.k.a., jumbo CDs, and normally have a penalty for early withdrawal (often 3 months or 6 months interest, though some CDs may have a penalty to your principal, as well)—read the fine print.
----CD interest rates are usually listed as both the non-compounded rate and the compounded rate (usually daily) or APY.
----Some CDs will allow the interest to be paid into a money market or savings/checking account instead of retained and compounded.
----Although there is no guarantee this will continue, in recent years CDs have paid better interest than comparable maturity Treasury bonds, mortgage securities, or high rated corporate bonds.
----The best rates on CDs have been through specific credit unions (definitely not all credit unions), some of which can be joined even if you aren't automatically eligible. Sometimes you can find a special rate (to attract customers), including at banks. Rates can be found through bakrate.com (linked above). Also, check your local banks and credit unions, especially for special offers.
----In taxable accounts, CDs are taxed at your marginal rate and have no tax advantages of any kind (so, comparisons with Treasury and US Savings bond need to take their state and local tax-free advantage into account).
----Because of the penalties for early withdrawal, CDs are not very “liquid,” so they may be inappropriate if you may need the cash before they mature (e.g., for emergency funds) or if you need steady cash flow.
----To get better cash flow, as well as to get average interest rates over time, you can build a “CD-ladder” (ladders can also be built using bonds or a combination). This is especially important nearing retirement.
----If you are gradually putting money away, you can simply buy 5-year CDs, which normally pay higher interest rates, whenever new money comes available, eventually building a ladder of 5-year CDs that can be rolled over into new 5-year CDs when they mature (or the money used for expenses or other investments).
----If you have a large sum or money, you can start a CD ladder by breaking the lump sum into smaller amounts and buying CDs of different maturities, rolling them over into 5-year CDs as they mature. Usually, this will get you less interest than just putting the lump into a 5-year CD, but this has to be done to get liquidity for the long run. It works best when the “yield curve” is flat (not that much difference between different maturities).
----Some people are convinced, if interest rates are low that it is best to buy shorter maturity CDs then roll them into longer ones when interest rates go up. If you think this, be sure to calculate how soon and by how much rates would have to change to make up for a lower starting rate.

Are There Any Alternatives to Fixed Rate CDs in Case Interest Rates Do Go Up?

----Some banks and other institutions are now offering CD-like instruments that protect your principal, while providing for the possibility of an increase in dividend under certain conditions.
----A “bump-up” CD will increase the dividend if prevailing interest rates (on CDs or on Treasuries, depending on institution) go up to a certain level; some offer a couple of bump ups. These CDs guarantee the initial APY until maturity, but because of the bump-up provision, the initial APY will be less than you would get on a similar maturity fixed-rate CD. (Compare with laddering as a hedge against rising rates.)
----There are now also market-indexed CDs that will protect your principal, but base your dividend on how well their target stock index (typically S&P 500) does. These differ on how they work (and there will probably be new variants if they gain popularity). You may get a fixed minimum (below what is being offered on fixed-rate CDs) with variable increases tied to market gains above the minimum (or higher). Or, there may be no minimum, with your dividend totally dependent on the market index.
----Market rate CDs will only pay out a % of market gains and they may cap the gains on which they will pay any %. So, if you are tempted, it is especially important to read the fine print. For example, if they cap the market returns on which they pay a % each year, as opposed to over the maturity of the CD, you may have little to show for your investment even with a solid increase in the market index, if most of the market gains happen in just one or two of the years over the life of a 5-year CD.

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US Savings Bonds
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Are US Savings Bonds a Good Alternative to CDs?

----Yes, US Savings Bonds are a good alternative to CDs, with some advantages and disadvantages.
----To summarize: US Savings Bonds are exempt from state and local taxes and delay federal taxes until the time you cash them in. After 5 years, there is no penalty for cashing them in, making them completely liquid (though you then have to pay federal taxes if you cash them in). On the other hand, they tend to pay lower interest over the long term than the better 5-year CDs, and you can achieve reasonable liquidity with CDs if you ladder them.
----Perhaps the most important advantage of US Savings Bonds is you can buy them in small amounts (denominations), currently as little as $50 for I-bonds and $25 for EE-bonds (which are bought for half the “face-value” they will be guaranteed to reach by a certain date). http://www.publicdebt.treas.gov/sav/savseree.htm
http://www.publicdebt.treas.gov/sav/sbidenom.htm
----This possibility of buying in small denominations, much lower than the minimums for Money Markets or CDs or Treasuries, have made US Savings Bonds the only viable alternative to Passbook Savings accounts for people with little cash to plunk down at one time, as well as a favorite choice for gifts.
----There is also quite a history to Savings Bonds (think of those WWII “Buy War Bonds” posters with Uncle Sam), although they now only provide a small contribution to paying for the national debt, and there are many in the Treasury Department who would like to see them eliminated as an inefficient way for the government to raise money.

How Are Savings Bonds Purchased and Redeemed?

----At present, you can purchase Savings bonds in 2 forms: paper or electronic. (The Treasury intends to eliminate paper Savings bonds in the future.) An individual may purchase up to $30,000 of each series (I-bonds and EE-bonds), in each form, during a calendar year. That is, you may buy $30k paper I-Bonds, $30k electronic I-Bonds, $30k paper EE-Bonds, and $30k electronic EE-Bonds per person. Paper bonds may be bought through most banks, S&Ls, and credit unions. Electronic bonds may be purchased through TreasuryDirect:
http://www.treasurydirect.gov/indiv/indiv.htm
----A bond's value increases on the 1st day of each month, so it is best to purchase a bond as late in the month as possible (without being so late as to purchase the bond at the start of the next month!). The issue date is the month & year of purchase; the day of the month is not considered.
----US Savings Bonds, like CDs, are redeemed from the issuer (in this case the US Treasury) not sold on the bond market. (Calling them bonds is confusing, for this reason.) Also like CDs, the interest is compounded within the Savings Bond, not paid out, as with most tradable bonds. A Saving Bond's value increases monthly, but compounding is only semi-annually,
----You cannot redeem a Savings bond until 12 months after the issue date. If you redeem a Savings Bond within the first 5 years after issuance, you will forfeit the last 3 months of interest. ------Paper bonds may be redeemed at most financial institutions (it is best to use an institution at which you have an account, otherwise the amount you can redeem at one time may be limited).
----Electronic bonds may be redeemed via TreasuryDirect. A bond's value increases on the 1st day of each month, so it is best when redeeming a bond to do so as early in the month as possible.
----You can find out the present value of your bonds by using the online Savings Bond Calculator:
http://www.publicdebt.treas.gov/sav/savcalc.htm
----You may also download and install a Windows-based application, the Savings Bond Wizard:
http://www.publicdebt.treas.gov/sav/savwizar.htm

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.
----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). The bond's value is guaranteed to double during the original maturity period. Thus, if you hold an EE bond up to original maturity, you know exactly how much it will be worth in nominal dollars (twice what you paid for it). For more information, see the Treasury's FAQ for fixed rate EEs:
http://www.treasurydirect.gov/indiv/research/indepth/eefixedratefaqs.htm
----Older EE bonds—those purchased prior to May 1, 2005— earn a variable rate that is set every 6 months, based on 90% of the average yield on 5-year Treasuries over the preceding 6 months. These older EEs are also guaranteed to at least double in value at original maturity. However, because the interest rate is variable, their actual value at original maturity 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
----The original maturity date (i.e., how long it takes until a EE is guaranteed to double in value) varies, based on when the bond was purchased:
http://www.publicdebt.treas.gov/sav/savmat.htm
----For more information on EE bonds of both types, see:
http://www.publicdebt.treas.gov/sav/savinvst.htm
----I Bonds are more complicated than EE Bonds. Their interest rate is composed of two portions:
----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 determined 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 will be negative (deflation) for a 6-month period. In this case, the composite rate (i.e., the interest rate earned) will become less than the I-Bond's fixed rate. However, the composite rate can never be less than 0% and subtract 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 different series of Savings bonds, as well as much older EE-bonds with different rules. 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
----When EE- or I-Bonds reach their 30-year limit, if you choose not to cash them in, you may rol them over into HH-Bonds. However, the Treasury has reduced the interest rate on HH-Bonds to 1.5%, so cashing in and paying taxes may prove the better choice.
----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?

----As always, it depends…. The question is whether or not the inflation adjustment component of I-bonds will be enough, over time, to make up for the lower fixed rate of I-Bonds, compared to the higher fixed-rate of new EE-bonds or 90% of the average yield on 5-year Treasuries of older EE-bonds. There is no way to know for sure.
----Over any short period, one type of Savings Bond will almost certainly win out and, sometimes, as with the recent surge in inflation, I-bonds can be a good 1-year (or so) savings device, even with a loss of 3-months interest. Unfortunately, many people look at the latest composite number on I-Bonds and expect that rate, when high, to continue. What really matters, long term (and these normally are long term savings devices), is the fixed rate.
----With the new fixed rate EE-Bonds, it will always necessary to look at the current difference between fixed rates. 1% versus 3.5% (November 2005) means CPI-U adjustments will have to average more than 2.5% as long as you hold onto them for I-Bonds to do better.
----With the older EE-bonds, pegged at 90% 5-year Treasuries, out best guide is history, though there is no guarantee the future will repeat the past, even over the long term. Historically, pegged EE-Bonds have beaten inflation by more than 2.25% on the average, which is a lot higher than the 1% fixed rate of current I-Bonds, though well below the 3% fixed rate I-Bonds of a few years back.
http://boards.fool.com/Message.asp?mid=22886644

Are The Tax Advantages of US Savings Bonds Good Enough to Make Up for Lower Yields?

----Maybe, but don't count on it, and crunch the numbers before making any decisions.
----US Savings Bonds have two tax advantages. Like Treasury Bonds, they have an advantage over CDs in not having to pay state and local taxes, which can be an important consideration if state and local taxes are high.
----The other advantage is delaying paying federal taxes until you cash in the Savings Bond (as opposed to CDs and Treasury Bonds, where you pay taxes on interest every year).
----If you stay in the same tax bracket at the time 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.
----Sometimes, especially after retirement, you may be in a much lower tax bracket (e.g., 15% versus 25%) when you cash in the Savings Bond, in which case the tax savings are considerably higher than just the compounding effect.
----With the older 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 for the compounding effect to make EE-Bonds the winner.
----In the new world order, what you need to look at is the difference between the fixed rate on the Savings Bond and the fixed rate on Treasuries or TIPS, then crunch the numbers, using the maturities on Treasuries and TIPS that best match how long you expect to hold onto the Savings Bond.
----More or less, if there is a difference of less than .5% in yield, 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.
----To calculate whether the tax delay advantage is sufficient to make up for a lower yield: 1) Choose a fixed yield for a currently available taxable option with which to compare; 2) figure out the after-tax yield (federal tax rate plus state and local taxes for CDs, just federal taxes for TIPS and Treasuries); 3) calculate compounded return at after-tax yield for the period in question; 4) find the before tax yield on the Savings Bond; 5) figure out the compounded yield at that rate for the period in question; 6) figure out the tax on the return at the rate you expect to be taxed at the time you cash in; 7) subtract tax from total; 8) compare totals.
----Note that for the above calculation, with TIPS and I-Bonds you need to assume a constant inflation rate (you can try different rates). You also have to assume the rate you will get from rolling over a CD or TIPS or Treasury will be the same as the initial rate you are getting.
----For more information on taxes, see the “Taxes” section of this FAQ, as well as this Treasury page:
http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_i_tax.htm

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An Aside on “Emergency Funds”
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So, What Is the Best Choice for an “Emergency Fund”?

----Since “emergency funds,” by definition, are money you must have for certain when you need it, they must be treated as fixed-income assets. This is not money that goes into stocks or into tradable bonds or volatile bond funds, where you risk losing principal selling into a down market.
-----The real issues are how much of an emergency fund you need and how to optimize the need for liquidity with the desire for the highest return possible (given the requirement to minimize risk to principal)?
-----Although “emergency fund” has become the standard term, it is misleading—“contingency fund” is more accurate. We all have to deal with run-of-the-mill unexpected expenses, such as the car breaking down or the pipes bursting or traveling to visit a suddenly ill or deceased relative. The amount of money needed for these is typically less than a few thousand dollars and best handled by keeping enough in a money market or savings account to cover such expenses or by using credit cards to get you through until the bill comes due, presuming you have other safe assets or enough cash flow to pay off the bill, without accumulating credit card debt (for example, you could skip an automatic drip into a stock fund to pay the bill).
-----The bigger concern is saving for contingencies where, if life goes according to plan, you will never need to use the money and by time you reach retirement the money will merge with your other investments and savings. Common undesired contingencies would be losing a job or an extended illness or injury.
-----How much money to put away is always a debate. Optimists (which includes most givers of financial advice) think as little as 3-6 months of expenses. Pessimists look at 3 years or more, including paying for your own health insurance.
----At issue, of course, is how much of your savings to devote to fixed-income assets with typically lower returns and how much to make available for more volatile assets that typically provide higher returns in the long term. A compromise approach is gradually to build a longer contingency fund by limiting your choices for your bond/fixed-income asset allocation to those with low risk to principal, even if this means some sacrifice on yields or possible capital gains or rebalancing bonus. For example, a CD ladder or regular purchases of US Savings bonds may historically have provided less of a long term return than an intermediate or long-term bond fund, but are not at risk of losing principal. Once you have reached your contingency fund ideal, then you can look toward future allocations into bonds/fixed-income in terms of optimal asset management.
-----Another compromise may involve sacrificing tax advantages of holding fixed-income/bond assets in tax-deferred accounts and stock assets in taxable accounts, until you have enough of a contingency fund in your taxable account. (Some contingencies do allow withdrawals from tax-deferred accounts.)
-----Where to put money for a contingency fund is the other question, since you are trying to optimize liquidity versus return. Probably, this will change as you gradually build up your contingency savings. Initially, you may want to keep some money in a money market or savings account, if you are using US Savings Bonds, because EE- and I-bonds cannot be cashed in, even with a penalty, until after one year (until 5-years there is a 3-month interest penalty), eventually just having the Savings Bonds. Other options are CDs with interest-only penalties and short-term bond funds. The best choice will depend on your personal circumstances and which asset (after-penalties) looks most attractive at a given time.
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