Savings Bonds For Income And Safety

By Investopedia Staff AAA

Savings bonds are often overlooked by investors searching for that perfect investment. However, savings bonds represent a safe investing vehicle with added benefits that many products don't offer.

For those unfamiliar with or needing a refresher on these products, savings bonds are U.S. government debt obligation; bonds are backed by the Treasury Department and monitored by the Bureau of Public Debt. Savings bonds are non-negotiable securities (unlike stocks, which fluctuate daily) that pay an interest rate that is compounded semiannually and accrued monthly.

SEE: Top 6 Uses For Bonds

4 Reasons to Buy Savings Bonds
Because savings bonds are backed by the U.S. federal government, these bonds are considered to be one of the safest investments available. They provide a steady stream of interest income while preserving the value of your principal.

There are five main benefits of purchasing savings bonds:

  1. Competitive Interest Rates
    The U.S. government offers interest rates that are often competitive with the market. Some bonds are adjusted for inflation while others are offered at a discount on an accrual basis, guaranteeing redemption of face value after 17 years. In addition to this, all bond interest payments are compounded semi-annually and accrued monthly so that your investment grows faster.

    This monthly interest accrual is something that is not usually found in most other bonds. For example, in a corporate bond, you receive your interest payment every six months. In the Series EE and Series I savings bonds, the interest is calculated monthly and then reinvested rather than paid out. For calculation purposes, the government will use the value of the bond on the date that compounding is to take place to calculate the interest payment.

  2. Tax Perks
    Because the U.S. government issues savings bonds in the hope of attracting more people, they sweeten the deal with added deferred and exempted tax benefits. All of the interest income earned on these bonds is completely exempt from state and local income taxes and postponed from federal taxes until redemption or maturity.

    This can be an important issue for many investors, especially those in the higher federal tax brackets or those living in regions with high local and state taxes. Additionally, the interest may be exempt from federal income taxes if the bond is used to pay for the bondholder's educational expenses.

  3. Convenience
    Savings bonds also provide a convenience not readily found in other fixed income products. They are issued in eight different denominations starting at $50 and moving progressively up to $10,000. This produces flexibility for investors looking to invest sums of money in increments less than $1,000. Furthermore, these bonds can be redeemed at any time after the initial minimum holding period of six months. Keep in mind that if you do redeem early (before the five-year holding period), your principal will never decrease, although you will be charged a penalty equal to the last three months of interest payments.
  4. Easy Redemption
    Even though these bonds are not marketable, like a stock or corporate bond, purchasing and redeeming savings bonds is relatively straightforward. You can buy these bonds at any bank, or, by using major credit cards, you can even buy savings bonds online at the Bureau of Public Debt's website. Some companies even offer internal monthly purchase plans that deduct employee paychecks. Redeeming them is even simpler, as most banks will redeem the bonds with proper identification, even if you don't hold an account with them.

SEE: Common Bond-Buying Mistakes

Treasury Department Offers Two Products
Series I
Series I bonds are indexed for inflation, which is based upon the Consumer Price Index (CPI) for urban consumers. These bonds pay a fixed base percentage of real interest that is determined when purchased and adjusted for inflation on a semi-annual basis. More simply, the interest on these bonds is comprised of two components: A and B. The A portion is set at purchase for the duration of the bond, and it is what you will receive for its life of 30 years. The 'B' portion is adjusted every six months, according to the level of consumer inflation. By combining 'A' and 'B' by means of a special formula derived by the U.S. Treasury, we come up with the composite rate, which represents the interest rate that you will receive on your bond.

Series EE
Series EE bonds are accrual-based, which means that you purchase the bond at a discounted price, and the interest earned accumulates so that the bond matures at face value or higher. Interest is based on 90% of the average yield on a five-year Treasury security; it accrues monthly but is compounded semi-annually. The EE savings bond is purchased at half of the face value because the bond is guaranteed to reach face value after 20 years. After the 20 years, the bond will continue to accrue interest up until its maturity at 30 years from purchase.

All of these products are available to any U.S. citizen or resident with valid social security numbers. This includes residents of Puerto Rico, civilian employees of the U.S. armed forces and military personnel. Even residents of Canada or Mexico working within U.S. borders for companies that offer a company savings plan can purchase U.S. savings bonds. If you live outside the U.S., chances are that a similar savings bond exists in your country. Individuals that do qualify for purchasing these savings bonds are restricted to a yearly limit of $30,000 face value, but the purchase of one series does not affect subsequent purchases of the other.

The Bottom Line
While savings bonds might not be the most interesting financial topic, they provide excellent safety and tax advantages. We'll let you decide whether an investment in savings bonds suits your portfolio needs.

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