A Risk Free and Tax Free 3.5% Return: Savings Bonds

I’ll let you in on a dull secret about me. I like Savings Bonds as a potential investment. I like them so much in fact that back in 2005 I wrote a thesis for my MBA on I-Bond Savings Bonds versus TIPS as investing vehicles. Trust me, rehashing that thesis would bore most of you readers so I will skip the details and instead tell you why I like savings bonds. For those who think this will be boring, note I’m about to share with you a little known option to achieve a risk and tax free rate of 3.5%.

Types of Savings Bonds

The first thing to understand is there are 2 types of savings bonds, I- Bonds which are inflation based securities, and EE bonds which are fixed rate securities. Both are backed by the full faith of the US Government. Both are State and local tax free. Interest is taxable by the federal government, however taxes are deferrable until redemption. In fact, there is a notable exception that if used for education during the year they are cashed out, they become federal tax free. So, in some ways they may be a fit for acting as a supplemental bond allocation for a 529 plan.

EE Bond Features

EE Series bonds are the investment I like in the current environment. While they return an almost non existent fixed rate of .1%, they have a rather interesting feature beyond their interest. They sell at half of their maturing value.  If you buy a $5000 dollar bond, and you cash it out after 20 years it will be worth $10K. This is an effective guaranteed return of 3.5% for 20 years, which well exceeds what you could get anywhere else in a risk free return. The downside is if you pull out any time before 20 years, your money will have earned only .1%. If you are looking for a long term investment where the money does not need to be liquid, perhaps a hedge against a 20 year mortgage or you have a kid that will reach college in 20 years, then this is a fantastic deal for the bond portion of your portfolio.

I-Bond Features

Meanwhile, I bonds are inflation based. They sell with 2 components. The first is a fixed component (F) determined at time of sale. In years past this rate approached as much as 3%. These days it’s 0%. The second is a variable component (I) determined by the current semi annual inflation rate that is recalculated twice a year. As long as inflation moves slowly, this will allow the value of the bond to adjust its return with the inflation rate. If inflation were to move too fast then the bond would not be able to keep up as the rate only adjusts once every 6 months. With a sudden inflation movement you would still lose money. The bond returns a rate equal to the fixed rate (F)+ the fixed rate multiplied by the variable half year inflation rate+ two times the variable half year inflation rate.

Fixed+Fixed x Inflation+2 x Inflation

So with todays 0% fixed rate the return is 2.76% or 2 times the semi annual inflation rate of 1.38%. Not bad compared to other current fixed income issues, but the return is equal to the rate of inflation so you’re preserving the value of your cash. The fixed rate like the inflation rate also changes once every 6 months in May and November. The highest it has been recently was last month at .1%. I do not recommend I-bonds for this reason, we can do better than just maintaining our purchasing power.

Additional I-Bond Features

Two additional feature of I-bonds to be aware of:

• In the rare case where inflation goes negative, they can never return less then zero.Your principle can never be lost. This is in stark contrast to the other federal government inflation indexed TIPS, which can have a negative interest rate if we enter deflation.
• While you cannot withdrawal them within 1 year of investment, from 1-5 years they are withdrawalable at a cost of only 3 months interest. At 5 years they can be withdrawn with no penalty. This makes them an ok choice for an emergency fund, if not needed for at least a year, and hedging to inflation is an acceptable return.

So about that paper. About 2 years after I wrote my paper showing how TIPS were trounced by I-bonds in almost any conceivable scenario the federal government enacted purchasing limits on both types of savings bond investments. You can now only invest $10K per individual plus $10K for a trust in I-bonds per year. It appears the government agreed with my take that savings bonds can be one of the best risk free investments given certain circumstances. I doubt they actually read my thesis though 😉

You can purchase Savings Bonds with no transaction cost from the government’s Treasurydirect.gov website.

Does your portfolio contain savings bonds?