A Guide To Saving With US Bonds

Ever wonder how to save some extra money? If you are anything like me you tend to spend your entire paycheck each time it comes in; sometimes before it arrives! My bank offers abysmal interest rates for savings and charges fees enough that the interest rate yield is negative. So how does one get an effective and worthwhile savings plan started with very little capital? One way is to save money with savings bonds.

What are Savings bonds?

Savings bonds are IOUs from the Federal Government of the United States. By purchasing one you own a little piece of the Federal debt and earn interest on your loan to the United States. According to the Treasury website (http://www.ussavingsbonds.gov/indiv/products) “EE bonds are a safe low-risk savings products that pay … a fixed rate of return “and I Bonds are “re a low-risk, liquid savings product.”

What’s the Difference between EE savings Bonds and I savings bonds?

I bonds pay a composite rate of interest. The first component is based on the current inflation rate and is designed to keep your savings ahead of inflation and the second component is a fixed element paying you for your loan. In contrast EE savings bonds purchased after April pay a fixed rate. Another difference is the purchase cost. EE bonds sell at ½ face value while I series savings bonds sell at face value.

How much will I earn if I save using Savings Bonds?

EE bonds currently earn a fixed 3.60% interest rate for bonds purchased through April 2007. Interest is added monthly and paid when the bond is cashed out. I bonds currently earn 4.52% through April 2007. I bond inflation component is re-calculated every May and November. Its fixed component is also announced each May and November but remains the same for the life of the bond. Both EE savings bonds and I bonds earn interest for 30 years.

How long is my money tied up?

One problem many people have in saving money is worrying about whether their funds will be locked away from them. This is not as much an issue when saving money with savings bonds. As we will see later savings bonds have several features that provide a nice alternative to expensive CDs and potential illiquidity sometime suffered by stock holders.

That said, both EE bonds and I bonds act as a poor man’s CD. That is they are a fixed deposit earning interest for a specified period of time. Both types of bond collect interest for thirty years. The agreed upon time in this case is a minimum of one year; exeptions to this rule include natural disaster or other emergencies. After one year you may redeem the bond for its current value less the last three month’s interest payments. Savings bonds held at least five years may be redeemed with no penalty.

So why use Savings Bonds?

Savings Bonds provide an attractive venue for long-term savings having interest rates competitive with many banks CDs and superior to many ‘high-yield’ accounts, but without the high entry cost, minimum balances or account fees. Additionally they enforce savings and can’t burn a hole in your pocket for at least a year after purchase. The interest they earn can be tax-deferred until they are cashed out. Additional tax benefits may be earned by using the proceeds for education.

I series Savings Bonds come in several denominations: $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. EE Bonds are available in the same denominations, but remember that they are purchased at ½ face value. This means you can start and maintain your high-interest savings plan for as little as $25.00! Most other types of accounts may require as much as $500.00 to open and charge you fees if you have less than $1500.00 balance on average. With Savings Bonds you just buy the bond and store it or leave it in your treasury direct (more on this shortly) account.

How Do I Purchase Savings Bonds?

Both types of Savings bonds can be purchased by US citizens at their financial institution or online at www.ussavingsbonds.gov via debit or credit card. A new option is to open a treasury direct account with the US Treasury. Treasury Direct lets you set up an allotment via your direct deposit account, select what kind of savings bonds to purchase, halves the minimum cost of I bonds to $25.00 and allows you to save your loose change in the form of electronic only bonds. Electronic bonds only exist in the treasury direct account and can be any penny denominated value of $25 or more such as $25.53.

Treasury Direct and Savings bonds provides a powerful tool you can use to turn your spare change into valued savings assets. Providing digital access, preventing easy redemption for a fixed period and offering competitive interest rates; saving money with savings bonds make a great nest liner for the Nest Egg you want to have.

Are Investment Bonds Right For You?

When it comes to investing fixed income over the past two years, the same sets of questions have arisen: Will the U.S. economy stabilize or tip towards a recession, especially now that the government shutdown is no longer a possibility but a reality. What will happen with inflation?

There are a number of different fixed income investments that are safe harbors for your money.Investment bonds are a great way to invest during times when interest rates are rising, but only by focusing on bonds that are short or intermediate term. Therefore, with shorter maturities on average, you are able to minimize the negative outcomes of prices falling. The theory is the longer the bond’s maturity, the more the prices will fall as the rate of interest rises.

When this happens, investors might consider a bond fund that is short term or intermediate. Some investors like TIPS – Treasury Inflation Protected Securities to help fight inflation.

However, funds that invest in TIPS have an exposure to the downside risk of dropping prices when there is an increase in interest rates. Therefore using TIPS now could be too late.

Investors that look to the long-term, who are not worried about taking some risk and not concerned with needs for fixed income, might consider multi-sector funds.

Another strategy could be Bond Laddering, which is a fixed income strategy where investors buy bond securities at different maturities.

This is quite similar to laddering of CDs the goal is the investor reduces his or her risk on interest rates and increases liquidity. This could be an alternative to purchasing mutual funds or even a compliment of that.

Bond laddering is best when the there are low interest rates, but they are expected to increase in the short-term. An example of this is a bond investor does not want to have all their savings tied up in a bond that is low yielding for a long period of time.

If the rates of interest were expected to make a sudden move up, then that bond investor would be able to buy into higher yielding investment bonds, as each of the individual bonds on the ladder begin to mature.

The same holds true if the interest rates at the time are high and expected to drop, using a bond ladder might not be the best as they will want longer term maturities like 5-year or even up to 30-year.

What Type Of Bond Should I Buy?

 

Most bonds are issued by one of three groups:

  1. the U.S. government or federal agencies;
  2. state and local governments, and
  3. corporations.

Here’s a breakdown of the types of bonds you can purchase from each institution:

Bonds issued by the U.S. government are called “Treasurys”…because, as you guessed, the U.S. Treasury issues them. There are four types of Treasurys:

Bills – maturities from 90 days to one year

Notes – maturities from 2 to 10 years

Bonds – maturities over 10 to 30 years

Savings bonds – redeemable without penalty after 5 years

All Treasurys carry the full faith and credit of U.S. government, which means that the U.S. Government has promised to pay you back. Another nice added benefit is that you don’t have to pay state or local taxes on any interest income you make on Treasurys. You can buy Treasurys on-line directly from the government. Savings bonds can be bought in very small amounts and are designed for small investors. For other Treasurys the minimum is $1,000.

Municipal Bonds

Bonds offered by state and local governments, or municipalities, are known as municipal bonds, or “munis.” Any interest income you make on munis is free from federal income taxes, and some states will also drop state and local income taxes (in that case your interest income is “triple tax free”). The trade-off for the tax break is that often you’ll get a lower interest rate than you may find with other taxable bonds. How much the tax break is worth to you depends on your income tax bracket and the state in which you live. The Bond Market Association provides a calculator to determine “equivalent taxable yield” on municipal bonds for you. Go to www.investingbonds.com for this information. But don’t buy munis for an IRA or other tax-deferred account where you already have a tax break!

Corporate Bonds

Corporate bonds are considered riskier than Treasurys and most munis because all companies are susceptible to competition, economic conditions and even mismanagement that can lead to uncertainty about their ability to pay bond holders and other creditors. The upside is that you will be compensated for taking this somewhat higher risk. The lower the company’s credit quality, the higher the interest rate you’ll be offered for buying the bond.

Corporate bonds come in three maturity ranges:

Short-term – 1-5 years

Intermediate term – 5-15 years

Long-term – 15+ years

Zero Coupon Bonds

By now you’ve grasped that coupon means interest. So why in the world would anyone invest in a “zero” coupon bond? Investing in a zero coupon bond doesn’t mean that you’ll earn no interest. It just means that you won’t receive your interest payment on a twice-yearly basis like regular bonds. Instead, the bond is sold to you at a discount – meaning you can purchase it for less than its face value. Then, when the bond matures, you collect true face value, that is, all of the interest plus principal in one lump sum. Why would someone want to buy a zero coupon bond? Well, for one thing zeros are more attractively priced than other bonds. And they’re useful for investors who are looking for a set payout on a given date instead of a steady payout stream over time.

Examples of investors geared for zero coupons? Someone investing for a child’s college tuition or looking for a lump sum upon retirement. One drawback is that unless your zeros are held in a tax-deferred retirement account or education IRA, you will have to pay taxes on the interest before you receive it, which may be a financial burden for some investors.

Why Should I Invest In Bonds?

 

  • Financial Security Who doesn’t like the sound of “financial security”? There’s a reason that a bond is called a “fixed-income” security – not only are you highly likely to get back your principal but you can also count on receiving interest on your investment.
  • Portfolio Balance & Diversification Bonds can be great financial “buffers.” When the stock market is on a roller-coaster ride, bonds can help steady your pulse because they’re a very safe financial tool to help balance the risk in your overall portfolio.
  • Tax breaks Who doesn’t want a tax break? One of the not so well known facts about bonds is that they’re very often free from many taxes. For example, most bonds issued by state or local governments (also known as “municipalities” or “munis”) are exempt from federal income taxes. All bonds issued by the U.S. Government (also known as “Treasurys”) are exempt from state and local income taxes. Some municipal bonds (“munis”) are free from all three – city, state and federal taxes – a condition known as being “triple tax free.”
  • Weighing the Risks Probably the first thing you’ve heard about investing is that it’s never risk-free. True enough. And although highly-rated bonds are considered one of the safest ways to invest your money, you should still take the risks into account before making any decisions.
  • Bankruptcy Bond issuers are not some mysterious “Wizard of Oz”-like entities. They’re companies and units of government. And, sad to say, companies and sometimes even local governments can go bankrupt and default on their loans. Bonds with high credit ratings very seldom default and U.S. Treasury securities are considered essentially risk-free. But it’s a fact to consider. Even bonds (except Treasurys) aren’t risk free.
  • Your bond is “called” Some bonds can be paid back early – what’s known as your bond being “called.” If you own a callable bond and it is called you will still be paid back your initial investment and any interest you’ve earned so far, but you will not receive the future interest you would have otherwise gained. From our example, let’s say your 9% bond was called after 8 years. You would be repaid your initial $1,000 investment (the principal), plus the $720 you had accumulated in interest. However, you would not receive the additional interest you were expecting when you made your initial investment for 10 years. Most important, if the company decided to call the bond, chances are that interest rates are now lower and you won’t be able to find a similarly rated bond paying as high as the original 9% interest you were receiving.
  • Rising inflation If inflation rises, the interest you make on your initial investment will look low compared to bonds currently being issued. And with your money locked in a bond, you could lose some principal if you sell it in order to move it into another investment that could give you a higher rate of return.
  • Selling your bond before maturity If you decide you need your money back earlier than the date that your bond matures, You’re taking “a chance” that you may get more, or less, than you paid. This depends mostly on the interest rates at which new bonds are being issued. That’s why individuals who invest in bonds typically plan to hold them till they mature. And that’s why it’s important to determine when you’ll want, or need, to reach your financial goal in order to purchase a bond that matures at that same time.Now that you understand the benefits and risks, you should better understand the importance of bonds as part of your overall portfolio – they add some safety and stability to your investment plan. Next let’s look at your bond buying options.