Are Savings Bonds a Sound Investment?

Savings bonds are issued by the U.S. Department of the Treasury (U.S. Treasury) and are debt securities. The proceeds from the sale of these securities are used to pay for the borrowing needs of the U.S. government. Because they are backed by the full faith and credit of the United States government, they are considered one of the safest investments to make. Savings bonds are also exempt from state and local taxes and the interest earned on the bonds can be tax deferred until redemption, unlike interest earned on regular savings accounts and CDs, where earned interest is fully taxable as ordinary income each year.

Savings bonds also differ from most other bonds on the market because in most instances they cannot be sold until maturity. Therefore, they should be considered a long-term investment. Further, since savings bonds are registered securities, if they are lost, stolen or destroyed they can be replaced.

U.S. Savings bonds can be purchased from commercial banks or over the Internet (Series I Savings Bonds must be purchased through a bank). As most commercial banks play the role of agent for the U.S. Treasury, a savings bond purchaser is able to fill out the forms at the bank after which they are forwarded to the U.S. Treasury. The purchaser will receive the paper bond(s) in the mail a few weeks later. Until January 1, 2011, paper bonds can also be bought through payroll deduction at many employers.

It is important to note that the U.S. Treasury changes the rules for these bonds periodically. Accordingly, interest rates will fluctuate depending on the date the bond was purchased and the series that was purchased. Consequently, there are two types of savings bonds being issued today and one that was available for purchase in exchange for an existing bond:

Series I Bonds

The Series I Savings Bond ("Series I Bond") was introduced September 1, 1998. The main purpose behind issuing Series I Bonds was to protect the investor from inflation. Accordingly, Series I Bonds are sold at face value and grow with inflation-indexed earnings for up to 30 years. Because Series I Bonds are inflation indexed, the purchaser does not have to worry about inflation, as the bond yield will change to reflect changes in the economy.

Series I Bonds are accrual-type bonds meaning that interest is added to the bond monthly. Interest accrues on the first day of the month, and is compounded semiannually. The earnings rate of a Series I Bond is determined by a fixed rate of return plus a semiannual inflation rate. Throughout the life of the bond, the fixed rate remains unchanged. The semiannual inflation rate, which is announced on May 1st and November 1st, changes based on the Consumer Price Index (CPI), as calculated by the Bureau of Labor Statistics.

In any one calendar year, you can buy up to $5,000 in Series I Bonds. Series I Bond denominations are available for purchase in increments of: $50, $75, $100, $200, $500, $1,000 and $5,000. Series I Savings Bonds mature (stop earning interest) 30 years from the issue date on the bond and post their final maturity interest on the first day of the final maturity month. If a Series I Bond is cashed within the first five years, the investor is penalized by losing the 3 most recent months' interest; after 5 years, the investor is not penalized. The interest can be deferred until the bond is cashed or can be declared annually on the investor's federal tax return. Ownership of Series I Bonds may be transferred; however, more restrictions are placed on such transfers than on transfers of other types of savings bonds.

As an example, an investor that purchased a Series I Bond on May 1, 2010 would be earning a composite rate of 1.74%. This rate includes the fixed rate of 0.20% over the life of the bond as well as the semiannual inflation rate that was declared in May of 2010 of 0.77%. To arrive at the 1.74%, the following formula is applied:

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]

It is important to note that the fixed rate will remain the same but the semiannual inflation rate will change every six months in May and November to whatever rate is established.

Series EE Bonds

Series EE Savings Bonds ("Series EE Bonds") were originally offered on July 1, 1980, to replace Series E Savings Bonds, which were withdrawn from sale. Series EE Bonds are issued for a 30-year term and principal and interest are paid in one lump sum at redemption.

Series EE bonds are purchased at a discount of half their face value and are sold in denominations of $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. You cannot buy more than $5,000 (face value) during any calendar year. Series EE Bonds are guaranteed to be worth at least their face value at the end of their term, yet they generally reach face value earlier and continue to grow in value.

Series EE Bonds are re-priced semiannually, and are assigned market based rates. Unlike Series I Bonds there is no inflation component. The Series EE Bond began as a variable rate bond, pegged at 90 percent of the average five-year Treasury securities yield for the preceding six months. However, as of May 1, 2005, the U.S. Treasury made the Series EE Bond a fixed rate bond. A new rate is still issued every six months, but the rate you get when you purchase the bond, is the one you receive for as long as you own the bond. The rate is now pegged to the 10-year Treasury average for the preceding month. For example, bonds issued between May, 2010 and October, 2010 receive fixed interest of 1.40% throughout the life of the bond. Since these bonds earn interest that varies based on the current economy, one never knows when the bond will reach its face value. This means that a Series EE Savings Bond could be worth more than face value when it reaches its final maturity date. It is advisable, therefore, to cash in the Series EE Bond after it reaches face value, but before the final maturity date (30 years after issuance) when the bond stops earning interest.

Ownership of Series EE bonds can be transferred, which is called a "reissue" by the U.S. Treasury provided certain tax considerations are addressed. The government extended the length of time a Series EE Bond must be held before it can be cashed. As of February 1, 2003, the minimum holding period went from six months to one year.

Series HH Bonds

Series HH bonds were available to be purchased in exchange for Series EE or E Bonds and Savings Notes, or with proceeds from a matured Series HH bond. As of September 1, 2004, this was no longer an option. Similar to Series I Bonds, Series HH bonds are purchased at their face amount in $500 to $10,000 denominations; however, there is no limit on the amount you can purchase. These bonds make their own taxable payments of new interest every six months. The new interest is exempt from state and local taxes, but subject to current federal taxes. The advantage of Series HH bonds was that they could be used to extend the tax deferral of interest on Series EE bonds and provide income. Series HH bonds have a maturity of 20 years.

Savings Bonds are an ideal way to make a safe investment that will grow over the long-term. Often, they can be used as gifts for birthdays, weddings, or graduations. The owner of the bond should, however, be aware of the rates and particular rules that apply to the series that he/she owns as well as what the bond is worth at maturity or when it reaches face value, including interest owed. Good luck and happy savings bond hunting!