Savings bonds have given small investors a way to save for generations. But lately, returns on savings bonds just haven't kept up with other investments.
Not so long ago, savings bonds were hard to beat. From 2000 to 2002, when the stock market was in the doldrums and short-term interest rates bottomed out at 1%, Series I savings bonds -- also known as I bonds -- were leaving their competitors in the dust.
The basics of I bonds
The magic of the I bond is in how its interest rate is calculated. When you buy an I bond, you lock in a fixed rate for as long as you own the bond -- up to 30 years. But that fixed rate doesn't determine your total income. Instead, it represents a real return; that is, a return that factors in the effect of inflation. In order to get the total return, you have to know how inflation has behaved in the recent past. Only then will you know exactly how much your I bonds will go up in value.
Here's an example. Say you own an I bond with a fixed rate of 2%. As of May 1, the rate of inflation over the past six months was 1.21%. Using a formula that combines these two rates, your annualized total return for the next six months would be 4.44%.
During the first few years of their existence, I bonds had relatively high fixed rates of 3% or more. But for the past several years, those rates have languished near 1%. With a current fixed rate of 1.3%, new I bonds offer a total return of just 3.74% -- well below corresponding rates on CDs, Treasury securities, and other similar investments.
Suffering from neglect?
It's clear that the Treasury hasn't been encouraging sales of I bonds with its interest-rate policies. During the time that I bond fixed rates have remained nearly unchanged, real returns on similar inflation-adjusted bonds have risen substantially. As a result, savings bonds no longer offer competitive returns.
Still, savings bonds do have their place. For one thing, they're available in very small denominations -- as little as $50. For those with just small amounts to invest, savings bonds are one of the few options available.
In addition, I bonds come with additional perks. You don't have to pay tax on the interest from savings bonds until you cash them in. In contrast, most bonds require you to pay tax on interest as it accumulates -- regardless of whether you actually receive income.
Even better, if you end up using the proceeds of the bonds for educational expenses for yourself or your kids, then the interest becomes tax-free. That can turn what looks like a low interest rate into a very attractive one.
Looking for inflation protection
If the idea of an investment that will rise if inflation spikes appeals to you, there are other choices out there. The government issues alternative bonds with similar features, as do corporations like SLM Corp. (NYSE: SLM) and HSBC (NYSE: HBC). Fannie Mae (NYSE: FNM) and Protective Life (NYSE: PL) also have issued inflation-adjusted bonds.
This month's brand-new edition of the Fool's Rule Your Retirement newsletter, which comes out at 4 p.m. today, includes a closer look at various inflation-protected investments. In addition to learning more about how these bonds work, you can find out which options are best for you. Take a free 30-day trial of the newsletter to get the inside scoop.
It seems likely that Series I savings bonds will remain in the investment background. Because of the way I bond rates are calculated, it's always possible that a period of high inflation will boost rates temporarily. That's what happened in 2005, when the combined inflation adjustments exceeded 4.5%. Unless that happens, however, you shouldn't expect to hear too much about I bonds in the future.
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