Remember that oversized, overly colorful $500 bill at the bottom of the sock drawer sent to you at birth by your Mom’s second cousin? It’s probably a savings bond, one of the most humdrum investments out there. But don’t let their conservative nature fool you. Savings bonds can be worth a look if you’re trying to decide what to do with cash but don’t want the risk of stocks or corporate bonds. Buying and cashing savings bonds is also much easier than it used to be, thanks to the Internet.
True to their name, savings bonds work like other bonds: they are a loan you make to the U.S. government, typically for 30 years. Savings bonds, like Treasury bonds, are debt securities issued by the Department of Treasury. In recent years, as savings bonds have gone online, the rules have changed. In the past, paper savings bonds were purchased at half of face value (i.e. you bought a $100 bond for $50). At maturity, you redeemed the bond for full face value instead of getting regular interest payments like most bonds. That made them what’s known on Wall Street as “zero-coupon” bonds—you got all your interest payments and principal back when the loan came due. Today, savings bonds accrue interest regularly. (We explain how interest payments and maturity work in our introduction to bond investing.)
There are two types of savings bond: Series EE and Series I. Both are purchased for face value, must be held at least one year and can be redeemed without penalty after five years. Series EE bonds pay a fixed rate of return and are guaranteed to at least double in value in 20 years. Series I bonds pay a variable rate of interest indexed to inflation, which means they protect you from a weak dollar in the future. Unlike Treasury bonds, savings bonds aren’t traded—you register your bond with the Treasury as if you made a personal loan to Uncle Sam (which, in fact, you do). The interest on savings bonds is exempt from state and local taxes (there is, however, federal tax on interest earned that can be deferred until the bond is redeemed.)
That old savings bond in your dresser probably came from a local bank: many financial institutions offered to sell and redeem savings bonds in the past. But starting January 1, 2012, savings bonds can now only be bought electronically through the Treasury’s Web site or via an employer-sponsored plan (these are pretty rare). You can buy any denomination from $25 and up, down to the penny, with a calendar year limit of $10,000.
Cashing savings bonds remains very easy: many local banks will redeem them for you or you can use the Treasury’s Web site if you purchased the bond electronically. There is still a penalty for early redemption: cash in before five years are up and you lose three months’ interest—not a particularly significant hit considering today’s low interest rates.
Like most other investment ideas, it depends. Interest rates are very low today and savings bonds rates are no exception. Series I bonds, the ones linked to inflation, are paying 3.06%. Series EE bonds yield just 0.6%. Savings bonds are certainly a decent replacement for cash that’s earning next to nothing in a savings account—a savings bond will never be worth less than it’s face value. Other not-so-risky investments that earn steady interest, such as certificate of deposits (CDs) or Treasury (T-bonds) bonds, are earning around 1% and 3% respectively.
Savings bonds are probably found in far fewer accounts today than a generation or two ago. The hassle of dealing with the Treasury, low rates, complicated rules and little faith that the dollar will hold its value have combined to make them something of an anachronism. Series EE bonds make a good gift for new parents or a new high school graduate, not much else. Series I bonds, however, have genuine value to the individual investor because their rate varies with inflation, that value-destroying force that can erase the purchasing power of your nest egg. There are other ways to hedge inflation, in particular Treasury bonds designed very similarly to I savings bonds (known as TIPS). But TIPS and other inflation hedges often cost a lot to get started while I savings bonds can be had for $25 and up. They’re worth a look as part of a diversified portfolio.
A credit default swap (CDS) is an infamous financial instrument that earned a bad reputation from its involvement in the recent financial crisis. The term refers to swapping the risk of a loan’s default with another party. An easy way to think of a CDS is a kind of insurance for debt lenders that can be bought and sold by investors other than the lenders themselves. Credit default swaps are a recent invention dating back only to the mid-1990s.