As the first part of this article discussed, savings bonds have for decades provided a way for small investors to save money. As the financial markets evolved, certain features of savings bonds have changed to follow suit. As recently as just a few years ago, savings bonds provided some extremely attractive investment opportunities for some savers. However, recent changes have generally made other types of investments more profitable than savings bonds.
Eliminating floating rates
One of the risks that bond investors constantly face is the threat of rising interest rates. Typically, when you purchase a bond, you agree to accept a certain interest rate until the bond matures. If prevailing interest rates go up in the meantime, then you're stuck with the lower rates on your existing bond and therefore miss out on higher payouts that new bonds may offer. Of course, this works both ways -- if rates fall, then you've locked in a higher rate until maturity.
Some bonds, however, have features that allow its interest rate to move from time to time. Just as most homeowners are familiar with the concept of adjustable-rate mortgages, these bonds adjust their interest rates depending on the behavior of certain benchmarks. For instance, an interest rate could be tied to the rate offered on 13-week Treasury bills; if short-term interest rates rise, then the interest payments you receive as a bondholder would also rise.
Until last year, series EE savings bonds gave investors the benefit of this adjustable-rate feature. This allowed savings bond investors to focus less on the timing of their bond purchases, because regardless of the current level of interest rates, future appreciation in the value of the bonds would be based not on current rates but on rates throughout the lifetime of the bond. For example, in 2003, series EE bonds paid between 2.5% and 3%. However, the adjustable-rate feature caused rates on these same bonds to rise to between 4% and 5% for the six months that began Nov. 1.
Now, however, series EE savings bonds have a fixed rate that applies as long as you own the bond. For instance, if you were to buy a series EE bond today, you would receive a fixed rate of 3.6%, regardless of what happened with interest rates in the interim. If interest rates in the economy rose, your bond's return would not increase.
The change on series EE savings bonds takes away much of what distinguishes them from other fixed-income securities. Because the rates on savings bonds are usually substantially lower than rates on other alternatives, such as standard Treasury securities and bank CDs, the appeal of buying savings bonds has been greatly reduced as a result of the elimination of floating rates.
Low rates on I bonds
Similarly, interest rates on series I bonds have changed for the worse over the past several years. As recently as 2001, you could purchase series I bonds that had a fixed interest rate between 3% and 3.4%. Because the overall interest rates for series I bonds is determined not only from the fixed rate but also from incorporating the impact of inflation, it was not unusual to see some of these bonds return as much as 9% during a brief period of relatively high inflation last year. Even if you assume a relatively modest average inflation rate of 3%, series I bonds with a fixed rate of 3% or more would provide an average return in excess of 6%, which compares favorably with similar bonds that don't include adjustments for inflation.
However, the Treasury has clamped down on the attractiveness of series I bonds by dramatically reducing the fixed interest rate. After falling as low as 1%, the current fixed rate on series I bonds is 1.4%. If you combine that fixed rate with the current inflation adjustment, you can determine that the rate on a series I bond bought today would be 4.52%. While this isn't a terrible interest rate, it is a bit less than even the shortest-term Treasury bills.
Holding periods and penalties
In addition to lower rates, there are other conditions that hamper savings-bond investors. The Treasury recently increased the minimum holding period for savings bonds to one year. This limitation completely prevents you from changing your mind about your bond purchase, no matter what financial challenges you face. In addition, if you cash in a savings bond during the first five years, you must pay a penalty of three months of interest. This discourages the use of savings bonds as short-term investments, even though bond rates have historically been lower than those of longer-term investments.
Alternatives to savings bonds
One reason why investors have traditionally accepted lower rates on savings bonds is that there used to be relatively few alternatives for investors with small amounts of money to invest. However, with the Treasury's development of the TreasuryDirect system, buying higher-yielding Treasury securities instead of savings bonds is now as easy as opening an online account and making an electronic transfer of funds from your bank account. In comparison with series EE savings bonds, five-year Treasury notes now yield 4.55%, nearly a full percentage point more. Similarly, 10-year Treasury inflation-protected securities offer a fixed rate of about 2.25%. You can buy a Treasury security with as little as $1,000.
Keep in mind, however, that while series EE and I bonds don't require investors to pay income tax on their interest until they cash in their bonds, most Treasury securities create taxable income for investors each year. Depending on your tax situation, the value of the tax deferral offered by savings bonds may offset or even outweigh the higher interest rates offered on Treasury securities. In addition, for those who have extremely small amounts of savings, savings bonds still offer a way to put their money to work immediately. By allowing purchases in amounts as small as $25, savings bonds are still one of the most accessible forms of investments.
In summary, while savings bonds still have value to some investors, they are not nearly as attractive as they were just a few years ago. Lower rates and greater restrictions on the use of savings bonds will likely cause their recent popularity to disappear and cause them to sink back into relative obscurity.
For more information on fixed-income securities like savings bonds, check out the Fool's Bond Center. You'll find everything from a beginner's tutorial on common words and phrases used in bond investing to specifics about various bond investing strategies.
Fool contributor Dan Caplinger locked in some good rates on series I bonds a few years back, but of course he didn't buy as much as he wishes he had. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is our bond of honesty.