If your childhood was like that of many Americans, you may have received a United States savings bond or two for your birthday — maybe from a grandparent or a generous aunt or uncle. Maybe you’re looking to start investing and are thinking about savings bonds as a potential investment.
What exactly is a savings bond? How do savings bonds work, why are they different from most investments, how do you buy and sell them, and what are alternatives to savings bonds? We’ll answer all of this and more below.
What Are Savings Bonds?
A savings bond is a type of debt instrument issued by the U.S. government in the form of a savings certificate. Savings bonds are issued at a deep discount to their face value ($50 to $10,000) and accrue interest every year until they reach full maturity.
For example, a Series EE savings bond with a face value of $50 can be purchased for $25, and grow in value a little every year until it reaches full face value, typically in 20 years. U.S. savings bonds are non-marketable, meaning that they don’t trade in the open market like most other bonds. (See how bonds work for more information.)
A savings bond is a loan from you — the bond owner — to the bond issuer, the U.S. government. As a lender, you earn money by charging the borrower interest for the use of the funds. It’s like a fancy IOU with interest.
The U.S. government issues savings bonds to raise money from the American public to fund civic projects and other endeavors that it deems necessary to manage the U.S. economy. Just like with other types of bonds, the government promises to pay back the buyer at a predetermined future date, the bond’s “maturity date,” at a fixed interest rate.
How Are Savings Bonds Different?
While U.S. savings bonds have much in common with other types of bonds, there are a few key features that can make them particularly attractive investment vehicles.
U.S. savings bonds have the advantage of being backed by the full faith and credit of the U.S. government, making them virtually risk-free. This factor makes savings bonds attractive to very conservative investors.
Accessible Purchase Amounts
In contrast to other types of bonds which are typically issued in amounts of $1,000 each, U.S. savings bonds can be purchased for amounts as low as $25 up to a maximum value of $10,000 in a calendar year. With low risk and lower purchase amounts, savings bonds are an excellent way to start saving. That’s why so many grandparents and parents gift savings bonds to their children.
Any interest earned from savings bonds is exempt from both state and local income taxes, making these investments very attractive for individuals living in high income tax states like California or New York. Federal taxes are deferred until the bonds mature, are redeemed, or stop earning interest after 30 years.
As an additional benefit, if the bond holder uses the interest earned from the bond to pay for higher education costs, the tax burden may be reduced even further (see IRS guidelines on reporting savings bond interest income).
Even though savings bonds have some tax advantages, a 529 account or Coverdell Education Savings Account offers substantially more tax advantages for a long-term goal like paying for college (see IRS Publication 970: Tax Benefits for Education).
Savings bonds have non-negotiable terms and cannot be transferred to a different owner. Practically speaking, that means that savings bonds do not trade in the secondary bond markets, unlike U.S. treasuries, corporate bonds, or municipal bonds.
The purchase of a U.S. savings bond initiates a direct relationship between the bond holder and the U.S. government. However, if a bond is lost or damaged, it can be replaced or reissued since it is registered with the government using the owner’s Social Security number.
Because the original bond purchaser cannot sell their savings bonds to another investor, the bond will never fluctuate in value prior to maturity, unlike corporate or municipal bonds that regularly change hands in the bond market at prices different from when they were issued.
The savings bond purchaser will receive their original investment back (and any interest owed up to that point) when they go to redeem the bond. If they hold the savings bond until maturity, they will receive the full face value.
Purchased at a Discount and Redeemed at Face Value
Unlike other types of bonds that pay interest to the bondholder annually or biannually, U.S. savings bonds are zero-coupon bonds. This means they are purchased for less than their face value, and do not pay the bondholder any earned interest until they are redeemed or reach their maturity date.
At this point, the bondholder will be paid a lump-sum interest amount, along with the repayment of their initial investment. This is different from a typical bond, which pays the bond holder regular cash interest payments, typically every six months, until the bond matures.
A savings bond’s implied interest still compounds semi-annually, accruing every year that the bond is held, or for its 30-year term. Once a bond has been held for 30 years, it will no longer generate interest for the investor and should be redeemed. However, savings bonds do not generate cash flow.
Lack of Growth
U.S. savings bonds offer investors a very long time horizon of 20 years or more, but without the potential for growth. Returns may keep pace with inflation (see more on Series I bonds below) but are not designed to grow in value that exceeds inflation. Thus, for a long-term goal like saving for college or retirement, there’s a mismatch of investment vehicle with the time until you need the money. Typically, a long-term investor would include growth investments such as stocks in their portfolio to make sure their savings grew faster than the cost of living.
What Kinds of Savings Bonds Are Available?
Now that you know how bonds work and what makes U.S. savings bonds a unique investment vehicle, it’s time to understand your options. Currently, there are two types of savings bonds available for purchase through the U.S. Treasury Department: Series EE savings bonds and Series I savings bonds. While each has the benefits listed above, the two types of bonds vary in their interest rate structure and the length of the term.
Series EE Savings Bonds
Perhaps the more straightforward of the two types of bonds offered by the U.S. Department of the Treasury, EE savings bonds offer a fixed rate of return that is determined by the day the bond is purchased. For instance, series EE bonds purchased between May and October 2019 will earned a fixed annual rate of 0.10%. After purchase, the bond will then earn interest at that fixed rate over a term of 30 years.
As an important note, EE bonds held for at least 20 years are guaranteed to double in value — regardless of the fixed rate. So, whether you purchased $25 worth of EE bonds or $10,000 in the year 2000, your principal would double by 2020.
Since the rate of return on a Series EE bond is so low for a long-term goal and does not offer inflation protection, they don’t make sense for most long-term investors. However, an investor who is extremely risk averse might consider them if they are primarily concerned with protecting the value of their investment vs. growing their money.
Even so, there are other low-risk investments that offer more liquidity (ability to cash them in easily) and can respond favorably to positive changes in interest rates, such as high-yield savings accounts, money market funds, Treasury bills and notes, and Certificates of Deposit. A small Series EE bond could also make an interesting gift for a younger child to introduce them to investing.
Series I Savings Bonds
Series I bonds earn interest and offer inflation protection. There is no single fixed interest rate and they are not guaranteed to double in value after 20 years.
Series I savings bonds offer a maturity term of 20 years — with an optional 10-year extension — and a variable interest rate. The interest rate for Series I savings bonds is calculated by adding a fixed rate that is set at the time of purchase to a variable interest rate that is adjusted twice a year for inflation in accordance with the Consumer Price Index for Urban Consumers, or CPI-U. According to the U.S. Treasury Department, the current composite rate for Series I bonds as of May 2019 is 1.90%. This combines the 0.50% fixed rate of return with the March 2019 CPI-U rate of 1.40%.
This means that if interest rates rise, the rate on Series I savings bonds will be adjusted upward, providing protection during inflationary times. In fact, this recently occurred as the CPI-U increased 0.70% between September 2018 and May 2019. However, if deflation occurs, the composite interest rate of these bonds guarantees that the interest rate will not fall below 0.00%, making them a hedge against deflation.
For a conservative investor concerned about inflation eating into their retirement income, Series I bonds purchased many years prior to retirement could be one component of their retirement income strategy.
FYI, the U.S. Government also issues TIPS (Treasury Inflation Protected Securities), which trade in the secondary bond market and offer similar protections and benefits. Here’s a handy comparison of Series I bonds and TIPS.
How Do I Buy Savings Bonds?
If you’ve gotten this far and decided that you’re ready to add savings bonds to your portfolio, it’s important to point out that there are a few requirements before you even think about moving on to the actual transaction.
First of all, you must be a U.S. citizen, U.S. resident, or U.S. government employee (regardless of your nationality). Second, as mentioned above, while you can purchase these Treasury bonds in values as little as $25 and in penny increments from there, the maximum investment you can make in savings bonds is $10,000 per calendar year.
How to Purchase Series EE Bonds
Paper bonds are no longer issued for Series EE bonds. They can only be purchased electronically through the U.S. Treasury website, TreasuryDirect.gov. Investors must provide a Social Security number (SSN), a valid email address, and the details for their checking or savings account in order to complete their purchase. If you’re buying them for a child you will need the child’s Social Security number. From there, it’s a simple online transaction.
How to Purchase Series I Bonds
Investors can also purchase Series I bonds through TreasuryDirect.gov with the required credentials. You can purchase up to $10,000 electronic bonds per Social Security number each calendar year.
However, the U.S. Treasury Department still issues paper bonds for Series I, but no longer sells them through financial institutions. If paper is your thing, you can buy up to $5,000 in paper bonds, but only through your tax refund using IRS Form 8888.
How Do I Cash in Savings Bonds?
The ultimate goal of investing in savings bonds is ultimately to recover your initial investment, plus interest. With that goal in mind, there are two key factors to consider when deciding to cash in your savings bonds: when and how.
When to Cash In Your Bonds
While buying U.S. savings bonds is an important financial decision, so is deciding when to redeem or cash them out. If you want to maximize the value of your bonds, you’ll want to hold them long enough to realize your gains from interest payments, but not longer than their maturity date — which is set at 30 years for EE bonds and 20 for I bonds.
Although these bonds have maturity dates that span up to two or three decades, you don’t necessarily have to wait for the bond to mature in full to redeem it. An investor who received savings bonds as a child and wants to invest that money to grow might want to redeem them prior to maturity.
There are a few important milestones when it comes to redemption. First, you must wait at least 12 months from the date of your initial bond purchase — whether you choose to buy EE or I bonds — in order to receive at least the face value of the bond.
Secondly, if you redeem the bond within the first five years of when you purchased it, you would forfeit the last three months of interest payments as a penalty. For example, if you choose to redeem your bond 50 months after purchase, you will only receive 47 months’ worth of interest. The good news is that if you can wait five years, there is no penalty for redeeming your bond.
Finally, if you’re thinking about redeeming your bonds but would like to know how much each is worth before you cash them out, the Treasury offers a handy online calculator to let you see how much you can expect to redeem them for.
How to Cash Out Your Bonds
Once you’ve waited at least 12 months from the purchase date — although a five year minimum is preferable — you can redeem your bond in different ways depending on the type you have.
Because the purchase and administration of EE bonds is carried out entirely online, they must be redeemed through TreasuryDirect.gov, and require a minimum redemption amount of at least $25.
I savings bonds can also be redeemed through TreasuryDirect.gov with the same requirements as EE bonds. However, as I bonds are still issued as paper bonds, you also have the option to redeem those physical bonds at your bank or credit union. There is no minimum redemption amount to do so. If you choose this method, you’ll need to bring proper identification, such as a driver’s license or passport, in order to receive your bond payout.
While there are many benefits to purchasing a U.S. savings bond over other types of bonds — specifically their tax advantages and almost risk-free nature — that safety comes at a high price. Because of their low-risk nature, the interest rate on savings bonds tends to be very low. As a result, interest payments may only match — or be less than — the inflation rate.
That said, this type of investment is an option for individual investors who are highly risk averse and either: need to balance out a portfolio with more secure investments, live in a high income tax state, or want to protect some of their retirement income from the risks of inflation. A low denomination Series EE bond could also make an easy-to-understand financial gift for a younger child.