Quick: What’s an investment that is risk-free, guarantees your money back and currently offers a higher return than the Standard & Poor's 500 stock index?
If you didn’t guess U.S. savings bonds, don’t feel bad. Many people think of them as old-fashioned gifts given by grandparents for college funds, not “sexy” investments like real estate or global mutual funds. But now that the rate of inflation is rising, they’re looking especially enticing now.
On Nov. 1, the government boosted the yield on Series I, inflation-adjusted savings bonds to 6.73 percent through April 2006. (The same bonds paid 4.8 percent over the most recent six-month period). So if you buy a Series I bond before May 1, you’ll earn interest at a rate that is twice the average yield nationwide on 1-year bank certificates of deposit (CDs), and around 2 percentage points above the average yield nationwide on 5-year CDs, according to Bankrate.com, a Florida company that tracks interest rates.
The S&P 500 index is up about 4.6 percent so far this year.
So why invest in a risky stock that doesn’t even guarantee a return when you can get a better return that is backed by the U.S. Treasury, asked Tom Adams, author of Savings Bond Alert.
“There’s not a whole lot of other investments in the world today that give you that rate with safety and security. The investment is also tax-deferred, so you don’t have to report the interest until you cash in. It’s a win-win situation.”
You can buy them easily, either through your local bank or credit union, or online at the government’s TreasuryDirect Web site. And the minimum requirement is cheaper than most mutual funds: For paper Series I bonds, the minimum investment is $50; for electronic Series I bonds (bought online), the minimum is $25.
How Series I bonds work
Introduced in 1998, Series I bonds are recommended for individual investors since they’re designed to help your money keep pace with inflation, protecting the purchasing power of your dollars. So if you buy a $100 Series I bond today, you know you'll get at least that much when you cash it in plus a bit more, when you take into account the interest your bond earns.
(Another inflation-adjusted bond is the more traditional Series EE variety, whose interest is pegged to yields on Treasury notes, but financial experts say don’t bother with this type since it pays a paltry 3.2 percent, fixed for 20 years.)
Series I bonds really earn two rates of interest at the same time — one is a fixed rate of 1 percent that stays with your bond for its entire 30-year life, the other is a variable rate that changes every six months, based on the current rate of inflation.
To determine the inflation rate, the Treasury looks at the Consumer Price Index every March and September, evaluates the difference from the prior six months, uses that difference to set the I-bond’s rate for the next six months going forward, and announces the new rates on May 1 and November 1. Since a huge jump in inflation occurred between March and September of this year, mainly because of soaring energy costs, the current variable got a big bump up to 5.70 percent.
Remember that you’re not going to get that yield forever. Those future variable rates may be higher — or lower — than the one currently in place. If inflation falls, the next rate your bond earns will be lower than what it is now. So if it turns out that inflation runs at only 1 percent in the coming months, a Series I bond you buy today will earn interest at an annualized rate of just 2 percent for the six months starting in May.
But if inflation rises, your bond could earn even more. Inflation is hard to project, but “if you watch rates going on, you’ll see general increases across the entire economy, such as home mortgage rates, and that gives a flavor that rates will go up again," said John Quinn, CEO of SavingsBonds.com, an informational Web site about savings bonds. "By just how much, no one can say.”
Even though savings bonds are safe, they do not provide immediate income since the interest payments build up and are accessible only when you redeem the bond. You can’t do that until you've owned the bond for at least 12 months, so don’t buy one if you think you’ll need the money before then. And if you redeem in the first five years, you lose the last three months' interest earnings.
“But if the bonds paid 6.73 percent for the next 12 months, you could redeem them a year from now and still have made a healthy 5 percent, even with the three-months' interest penalty,” says Quinn.
Being bullish on I-bonds, Quinn recommends buying them on a regular basis. “You can hedge your bets by buying $1,000 a month for six months and if the rate goes up, you can cash in that and buy another bond. The actual dollar amount lost by cashing them in before five years is offset by the new rate being higher.”
Tax-free benefits
Like retirement funds, savings bonds are federal tax-deferred till you cash them out. Plus, interest is free from state and local tax. Adams recommends that bondholders ideally cash them out in a year when income is relatively low since interest is taxed as ordinary income.
And regarding the old-fashioned aspect of savings bonds being grandparents’ gifts, Quinn says one of the best things grandparents can do is to buy their beloved grandchildren savings bonds.
“If a child receives the bond, that child has a tax exemption of up to $800 in income. So if the bond earns $15 to $20 worth of interest and you report it on your child’s tax return, it won’t be taxed because of the exemption. If they’re given bonds annually until they’re 18, they don’t have a tax liability because they reported that interest year after year. You can cash those in and pay for college without any tax burden.”
So they may not be sexy, but savings bonds are proof that slow and steady wins the race. “No single investment in the stock market guarantees that type of percentage year over year,” says Adams. “If you expect the worst when it comes to investing, this is the way to go.”
By Vanessa Richardson
