Boring!

I know that is probably your reaction to the title of this article and I can’t really blame you.

There is nothing exciting about savings bonds and you’ll never get rich by investing in them. In fact, you may not even keep up with the cost of living. For most people, there are normally far better alternatives for long-term investments. Yet as we approach the end of 2020, a case can be made to use these mind numbingly boring savings vehicles. Individuals who find themselves in certain common situations could conclude that savings bonds represent the “least bad” alternative.

Bear with me and you might find that savings bonds could be a useful tool in your situation.

The Basics

Except in the case of electing to receive savings bonds through tax refunds, all bonds have been issued in electronic form for several years. TreasuryDirect offers an easy way for investors to purchase savings bonds as well as other treasury securities. Unlike treasury bills and notes, savings bonds are not marketable securities, meaning that the purchaser cannot sell these bonds to other investors. Instead, savings bonds are held by the investor until they are redeemed or reach maturity after thirty years. Savings bonds are not redeemable at all during the first year of ownership and bonds redeemed prior to five years incur a three month interest penalty. The government intends savings bonds to be a medium to long-term investment vehicle for small investors.

Savings bonds offer important tax advantages. They are free of state income tax and while you will be liable for federal income tax, the tax is only due when you redeem the bond or it matures after thirty years. This means that savings bonds offer tax deferral, a rare feature outside of retirement accounts.

There are two types of savings bonds currently offered by the government: Series EE and Series I. One can purchase up to $10,000 of each series every year. Let’s take a quick look at how the two series differ:

Series EE savings bonds earn a fixed rate of interest for the life of the bond. The current interest rate is a minuscule 0.1 percent. Why am I reading this, you might ask? Who in the world would sign up for a bond paying 0.1 percent for thirty years when the Federal Reserve has a 2 percent inflation target? Well, an important but often overlooked feature of the Series EE savings bond is that the government guarantees that the value of the bond will double if, and only if, you hold it for at least twenty years. A doubling of value over twenty years implies a 3.5 percent interest rate. But that is only the case for bonds held at least twenty years.

Series I savings bonds are intended to offer investors inflation protection. These bonds pay a fixed “real” return plus they earn the equivalent of the rate of increase of the consumer price index for urban consumers (CPI-U). Currently, the fixed “real” rate is 0 percent. That’s right, when you purchase a Series I bond, you are agreeing that you will receive no real return whatsoever. Your return will be comprised of only the rate of inflation as measured by CPI-U. In the unlikely event of deflation, the government guarantees that you will never receive less than the purchase price of the bond. Unlike Series EE bonds, there is no guarantee that Series I bonds will double over twenty years. The rate of return is entirely unknown at the time of purchase because the rate of increase of the CPI-U is unknown.

The government also offers Treasury Inflation Protected Securities (TIPS) but TIPS are not savings bonds. TIPS are marketable securities and have complexities that are beyond the scope of this article. However, I should note that the real return on TIPS is currently negative as of late December 2020, which makes the Series I fixed rate of 0 percent superior to TIPS at the time of this writing.

Now that we have a basic understanding of the two types of savings bonds, let’s consider how an investor might use each series.

The Case for Series EE Savings Bonds

There’s no doubt about it – the 0.1 percent fixed rate currently offered for Series EE bonds is pathetically low and inferior to many online savings accounts. There would be no reason whatsoever to purchase EE bonds for an intended holding period under twenty years unless you are expecting significant deflation and the imposition of negative interest rates on bank deposits. In such a situation, Series EE bonds could offer protection from negative rates.

So unless you are expecting deflation, why consider EE bonds?

Most small investors do not think in terms of matching the duration of their assets and liabilities. Insurance companies, for example, think of duration matching when they construct their portfolios. A life insurance company might have a high degree of confidence, from an actuarial perspective, that they will have to pay out a certain amount of nominal dollars twenty years from now. Many insurance companies will seek to match the duration of their investment portfolio to the duration of their expected liabilities.

Consider that mortgage rates are at historic lows in December 2020 with thirty year fixed rate mortgages available as low as 2.5 percent. Let’s say that Michael and Elizabeth, a newly married couple, just purchased a home for $475,000. They were able to make a 20 percent down payment of $95,000. The monthly payment on the $380,000 fixed rate 30 year mortgage works out to just over $1,500.

Michael and Elizabeth are both 35 and plan to retire in twenty years at the age of 55. This isn’t a starter home for them — they plan to live in it for decades to come and have a high degree of confidence that they will not be forced to relocate. Having a 2.5 percent mortgage for 30 years is very cheap money but they don’t like the fact that mortgage payments will continue beyond their retirement date.

The risk of inflation is a huge problem because most future expenses can and will rise as the cost of living rises. However, Michael and Elizabeth’s mortgage payment is fixed for the life of the loan. It will be $1,500 per month or $18,000 per year during the first year and all subsequent years.

If the newlyweds want to provide for the mortgage payment during years 21 through 30 of the mortgage, when they will be retired, using Series EE savings bonds could be a perfect way to achieve this objective. By investing $10,000 per year in Series EE bonds for the next ten years, they know that they will have $20,000 per year during years 21 through 30 of the mortgage. Although they will have to pay income taxes when the bonds are redeemed, the proceeds should still be enough to pay the vast majority of the $18,000 annual mortgage service. The risk of inflation is not relevant in this situation because they duration matched the asset with the liability they know they need to service. And they are better off for doing so because the interest rate on the EE bonds will work out to 3.5 percent which is a full percent greater than the 2.5 percent rate on their mortgage.

Granted, this isn’t so exciting and the couple would very likely do better invested in an equity index over two decades. But few things in life are guaranteed. Using EE bonds to fund a fixed payment obligation bearing an interest rate lower than the EE bond rate is an option worth considering. Of course, there are risks. If Michael and Elizabeth cash those EE bonds even a month before reaching the twenty year mark, they will not earn 3.5 percent annually, but the miserable 0.1 percent fixed rate that would apply in the absence of the twenty year doubling guarantee. This is not an insignificant risk.

The Case for Series I Savings Bonds

The case for using Series I savings bonds differs from the Series EE scenario in terms of the duration of the commitment. Unlike Series EE bonds, Series I bonds are not guaranteed to double over twenty years. All you will ever receive from these bonds, at today’s 0 percent fixed rate, is the rate at which the CPI-U increases. This rate is reset twice a year and is currently 1.68 percent.

With online savings accounts paying only 0.5 percent as of December 2020, an investor could do better with Series I savings bonds even if the bond is held the bare minimum of one year. Sacrificing three months of interest would still result in a return of over 1.2 percent, more than double the rate offered by the highest yielding online savings accounts. Of course, if the CPI-U resets to a lower level in six months, the return the investor will get will be lower than 1.68 percent, but it seems unlikely that we are going to have disinflation or outright deflation in the United States given that the Federal Reserve is determined to create inflation of 2 percent, and perhaps more than that as the economy recovers from the COVID pandemic in 2021.

The idea of using Series I bonds as a substitute for one year treasury bills is also attractive given that the one year treasury yields just 0.09 percent as of late December 2020.

A significant limitation is that you cannot invest more than $10,000 per year in each savings bond series. However, the new year will soon be upon us. There is no reason that you cannot invest $10,000 in the remaining days of 2020 and another $10,000 in January 2021. In addition, you could direct the IRS to invest up to $5,000 of a tax refund in savings bonds. There is nothing prohibiting a taxpayer from overpaying 2020 taxes and directing the refund in early 2021 toward $5,000 of additional savings bonds. So, an investor could put around $25,000 into Series I Bonds in this manner over the coming weeks.

Picking Up Crumbs

Yes, this is all quite boring but we find ourselves in a very low return world and sometimes eking out just a small additional return can be worthwhile.

I have purchased I Bonds in recent days and will be doing so again in early 2021 with the intent of using these bonds as part of my bond ladder. In my case, I will likely hold these bonds for five years in order to avoid the three month interest penalty for cashing out sooner than five years. The five year treasury note currently yields 0.37 percent and it is hard to see the Series I bond returning less than that between now and 2025.

I am under no illusions that Series I bonds represent a good investment. They just seem to be the “least bad” alternative at the moment for funds that I plan to need within the next several years. For longer term commitments, owning well run businesses, either directly or via stocks, offers the prospect of better long term returns, but the key words here are “long term”. Anything can and will happen in equity markets over short periods of time. Having a bond ladder might be boring but it helps me sleep at night and prevents forced sales of stock at distressed prices.

Obviously, everyone has a different financial situation and these ideas may not make sense in your situation. As always, this isn’t tax or investment advice but hopefully the article was at least a little less boring than you thought it would be.