The stock market has finally seen some long-awaited volatility so far in 2018, with market indexes like the Dow Jones Industrials (DJINDICES: ^DJI) and the S&P 500 (SNPINDEX: ^GSPC) having climbed to all-time record highs before putting in a major correction for the first time in a long while. Amid increasing turmoil, investors are starting to turn to tried-and-true favorites for preserving their capital during rough markets. Yet before jettisoning a strategy that's worked well for nearly a decade, smart investors are rightfully thinking carefully before moving to what many perceive as safer alternatives to stocks.
One investment that's been around for decades is the savings bond. With a long history that dates back to World War I and beyond, savings bonds have a reputation for being the gift that a grandmother or grandfather gives to grandkids to help them start a long-term savings strategy. As interest rates start to move higher and stocks have seen ongoing pressure, some believe that now might be the time to take a closer look at savings bonds and how they can add diversification to an overall investment portfolio.
2 types of savings bonds
Savings bonds are debt obligations issued by the federal government. Just like Treasury bonds and other national obligations, savings bonds are backed by the full faith and credit of the U.S. government, making them effectively free of default risk.
Savings bonds come in two basic types. Series EE bonds pay a fixed rate of interest that's determined at the time that you buy the bond. The rate is based on prevailing market interest rates at the time of purchase, and the Treasury changes the rate on new bonds every six months. Unfortunately, the Treasury has set those rates at such low levels that series EE bonds aren't worth investing in. Currently, the rate is just 0.1%, and that's been the rate since 2015. However, there's one aspect of EE bonds that can make them slightly more attractive: If you hold them for 20 years, you're guaranteed to double your money. Even then, though, that works out to a long-term rate of just 3.5% -- a pretty modest return for such a long-term investment, although admittedly it's higher than what Treasury bonds currently pay.
Series I bonds are more intriguing. The value of these bonds is tied to inflation, with a fixed rate of interest added on top of whatever change in inflation occurs during the period as measured by the U.S. Consumer Price Index. So for example, if inflation rises 1% during a certain six-month period -- or an annualized rate of inflation of about 2% -- then the interest rate for the following six months will be roughly 2% plus the specified fixed rate. The current rate on I bonds purchased from now until Oct. 31, 2018 is 2.52%, based on a 0.3% fixed rate and a semiannual inflation rate of 1.11%. Again, that's not a huge rate for the long run, but it beats short-term savings account and CD rates right now.
Can savings bonds work for you?
Savings bonds aren't meant to be short-term investments. You have to wait a full year before you can redeem savings bonds at all, and until you've held it five years, you'll forfeit three months' worth of interest if you cash them in. So if you want quick availability of your cash, savings bonds won't typically be a smart move.
However, as alternatives to other fixed-income securities, savings bonds do have some advantages. Although they accrue interest, savings bonds don't require you pay to tax on that interest until you actually cash them in. There are even some provisions of the tax code that can let you treat the interest as tax-free if you use the proceeds for certain purposes. Moreover, unlike Treasury bonds, savings bonds never go down in value, and even if there's a major deflationary event, I bond rules prevent price adjustments from sending interest rates below zero. That might not seem like that big a deal, but with rates on the rise and bond prices falling, many investors are learning the hard way that bonds aren't as safe as they originally thought.
Savings bond purchases are capped at $10,000 annually per person for each individual series, or a total of $20,000 if you buy both Series EE and Series I bonds. That emphasizes the small-investor focus of the program, and it also prevents investors with larger portfolios from overly taking advantage of their unique provisions.
If you want to give a child or grandchild an investment that will truly grow over time, a gift of stock will work much better than a savings bond. But for those looking to diversify their portfolios with a fixed-income investment that has some favorable traits, Series I savings bonds are worth a closer look right now.