When it comes to investments that have stood the test of time, few can match the staying power of the United States savings bond. From their roots as "baby bonds" during the Depression through the "war bond" campaigns of World War II, savings bonds served a dual purpose of giving everyday people the chance to contribute modest amounts of money to help the nation's war efforts as well as give them an investment that would provide some income to savers. Following the end of the Second World War, savings bonds adapted to peacetime and recast themselves as a method to save and to participate in the public finance of the nation.
In more recent years, savings bonds have gone through a new period of popularity. Several new features, along with the introduction of brand new types of bonds, have raised the level of investor interest and made savings bonds more competitive in comparison with other ways of investing.
However, some new restrictions placed on savings bonds, along with further changes in the terms of investing in savings bonds, have lessened their attractiveness and threaten to return them permanently to the second tier of investment vehicles.
To understand the options currently available to savings bond investors, having a background of how savings bonds have worked in the past is helpful. The first part of this article provides some history on previously issued savings bonds.
The traditional savings bond
Several different series of savings bonds were available to investors during the 1940s and '50s. Some of these securities resembled other typical fixed-income securities in that they made interest payments to investors at regular intervals and matured after a certain period. However, many savings bonds had an accrual feature, whereby interest was not paid but rather accumulated until the owner chose to redeem the bond for cash. One benefit of the accrual bonds was that their owners didn't have to pay tax on the interest until they cashed in their bonds.
By the 1970s, many of the series of savings bonds had been discontinued. The most common remaining ones were series E and series H bonds. Series E bonds accrued their interest and had maturities of 30 or 40 years, while series H bonds made interest payments to bondholders every six months and matured after about 30 years.
When economic conditions caused a spike in interest rates during the late 1970s and early 1980s, the U.S. Treasury replaced these bonds with new series EE and HH bonds. Although the terms of series EE bonds varied substantially depending on exactly when they were issued, each bond of this type had an initial period during which a minimum guaranteed rate would apply. However, a bond might also qualify for higher market-based interest rates, depending on how long the owner had held the bond and the level of prevailing interest rates on other Treasury securities. Series HH bonds, on the other hand, paid fixed amounts of interest twice each year at relatively low rates of either 1.5% or 4%.
As interest rates began their steady decline during the 1980s and 1990s, the Treasury made several changes to the terms of series EE savings bonds. For instance, between 1982 and 1993, the minimum guaranteed rates on newly issued series EE bonds fell from 7.5% to 4%. After 1995, the Treasury no longer guaranteed any minimum rate on new series EE bonds. With rates tied to a percentage of the yield on five-year Treasury notes, interest rates on some series EE bonds fell to less than 2.5% during 2003.
Savings bonds linked to inflation
The 1990s also brought innovation in the way that the Treasury financed the national debt. For the first time, the government issued fixed-income securities whose interest rates were tied to the rate of inflation. These Treasury Inflation-Protected Securities, or TIPS, offered investors a way to protect against the decrease in purchasing power that most traditional bondholders face. With a traditional bond, the $1,000 you paid when you first bought the bond would inevitably be worth far more than the $1,000 you got back at maturity simply because of inflation. With TIPS, however, your maturity payment would keep pace with inflation; the money you received at maturity would theoretically have the same purchasing power as the $1,000 you used to buy the bond. Although demand was initially slow when TIPS were first offered in 1996, demand eventually picked up dramatically. In addition, some private companies, including Sallie Mae
In 1998, the Treasury began issuing a new type of savings bond that incorporated a similar method of protecting investors from the effects of inflation. Series I bonds differed from traditional series EE savings bonds in the way that their interest rates were calculated. Unlike series EE bonds, the interest rates on series I bonds consist of two separate components. When this type of bond is issued, it is assigned a fixed interest rate that applies throughout its term of ownership. However, the total interest paid on the bond also includes an adjustment for inflation. The inflation adjustment is determined every six months by comparing the values of the consumer price index (CPI) at the beginning and end of the six-month period.
For instance, on a series I bond issued at the beginning of 2002, the fixed rate was 2%. To determine the rate currently being paid, you have to look at how much the CPI rose during the six months the Treasury uses to set the rate. Currently, the six-month adjustment being used is 1.55%. The total rate is roughly equal to the fixed rate plus double the six-month CPI adjustment. Using the slightly more complicated formula provided by the Treasury, the total rate currently paid on a series I bond issued in the first part of 2002 just exceeds 5.1%.
With all of these options, and with the stock market declines from 2000 to 2002, savings bonds gained support among investors and financial advisors. Their terms were often competitive with or even superior to the returns available from other common fixed-income securities. However, the Treasury has now made some changes that diminish the usefulness of savings bonds as an investment alternative. The second part of this article goes into greater detail about these changes and the effects they've had on savings bond investors.
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.