Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
The Fourth of July holiday has passed, but that’s no reason to snub U.S. Savings Bonds. The current rate of 7.49 percent on Series I bonds and 5.73 percent on Series EE not only beat CD rates at most banks and financial institutions, but they happen to have outperformed a whole list of mutual funds so far this year.
Of course, that is probably just a temporary condition, but the comparison of stock market volatility with higher saving-bond yields creates the perfect opportunity to issue a reminder of how savings bonds work.
Rates on all savings bonds change every May and November, based on either current market rates or on inflation. The traditional Series EE bonds pay interest equal to 90 percent of the average 5-year Treasury securities yields for the preceding six months. So the rates on EE bonds are based on rates set by participants in the huge government bond trading market.
The newer Series I bonds (referred to as “inflation-bonds”) carry a fixed base rate of 3.60 percent, plus a semiannual calculation based on the rate of inflation as measured by the Consumer Price Index for urban consumers.
Thus, with inflation running at a 3.82 percent annualized rate for the period from September 1999 through March 2000, added to the 3.60 percent base rate (plus some rounding), the total yield on I-bonds for the current six months is 7.49 percent at an annual rate.
At first glance, the choice of which to buy is obvious. You’d go for the current higher yield, which definitely favors the I-bonds. But think carefully about that decision.
Suppose the Fed decides to push interest rates even higher to slow the economy, despite few signs of inflation. Then the next round of rate increases could see the EE bond interest, based on market rates, creep up to the I-bond level.
And if the economy were ever to enter into a period of deflation, that basic 3.60 percent fixed rate of return on the I-bond could be chipped away. In a worst-case scenario, you could have a period in which you actually earned no interest.
But the real virtue of U.S. savings bonds is not the hypothetical argument about which type offers the better return. And it’s certainly not a debate about whether savings bonds stack up against long-term returns in the equity market. They lose that debate from the get-go.
The true benefit of savings bonds is very simply that they allow anyone to actually save money painlessly--while still earning a market rate of return. Plus, the interest earned is free from state taxes. And if the bonds are used by middle-income families to pay college tuition, the earnings may even be free from federal income taxes.
Parents or grandparents who give savings bonds, intending to use them for future college expenses, should be aware of the rules on the tax-free use of those bond proceeds for education. That means the savings bonds must be purchased in the name of the parent, not the child. The child may be named as a beneficiary on the bond, but may not be named as a co-owner.
The tax-free use of the proceeds for educational purposes applies only to middle-income filers--a definition that changes every year. For 2000, the full deduction of interest earned on savings bonds is available to those who have adjusted gross earnings of less than $54,100 on a single return, or $81,100 on a joint return.
And the proceeds must be fully used for educational expenses such as tuition and fees (but not room and board) in the calender year the bonds are cashed in.
Savings bonds still are sold at banks and financial institutions. But the Savings Bond division of the U.S. Treasury is becoming increasingly Web savvy. So for more information on how savings bonds work, go to www.savingsbonds.gov, where you can purchase individual bonds using your Visa or Mastercard, set up an automatic monthly checking deduction to purchase bonds on a regular basis, or even input a list of the bonds you own and instantly find out their current value.
If you’ve read this far, don’t let anyone laugh at your conservative instincts. Sure, savings bonds aren’t likely to outstrip the gains you can make in a diversified portfolio of stocks, over the long run. But they can certainly let you sleep while the stock market takes some volatile swings in the short run. And that’s the Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail at firstname.lastname@example.org. Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.