Series EE savings bonds are a reliable, low-risk savings product backed by the full faith and credit of the United States government. In a low interest rate environment Series EE savings bonds yield very little (just 1.20% in the first four months of 2010). Savers who want to earn more interest on their savings face a quandry: higher interest rate yield is associated with higher risk. So how can a conservative saver get more return without exposing herself to risk?
Fortunately, there are several alternatives to Series EE savings bonds that are also backed by the full faith and credit of the United States government that offer a higher yield at present.
Series I Savings Bonds
As an alternative to Series EE savings bonds, Series I (often referred to as I-bonds) offer some interesting features. I-bonds have two interest components: a fixed interest rate set at issuance (currently a meager 0.3%) plus a variable interest rate based on inflation (currently 3.06%). I-bonds purchased between Nov. 1 2009 and April 30 2010 will yield 3.36% APR. The variable interest rate is derived from the consumer price index (CPI-U), a fundamental measure of inflation. Interest is posted on the first of the month.
Series I savings bonds are intended to help preserve the principal from inflation risk. Even in a deflationary environment, the composite interest rate of an I-bond never goes below 0.
Series I bonds can be purchased online at TreasuryDirect.gov or in person at a participating bank. Up to $5000 each of paper and electronic I-bonds may be purchased per person per year. Paper I-bonds have a serial number and can be re-issued if lost or destroyed. Electronic I-bonds may be purchased in any increment to the penny. Paper I-bonds have a minimum purchase of $50.
I-bonds share some tax advantages with Series EE savings bonds. Interest earned is subject to federal income tax but this can be deferred until redemption or final maturity. Special tax benefits are available under the Education Savings Bond Program for those who use savings bonds to fund qualified education expenses.
There are some restrictions on the redemption of Series I bonds: I-bonds must be at least one year old before they are elgible for cash-in. (During times of a declared federal disaster, Series I bonds may be redeemed within one year of purchase.) If redeemed within five years of issue, there is a three-month interest penalty. Series I savings bonds may be cashed in at your local bank.
Finally, I-bonds are, like Series EE savings bonds, fully backed by the faith and credit of the United States government, making them among the safest investments in the world.
Treasury Inflation-Protected Securities, known as TIPS, are another alternative to the Series EE savings bond. Like I-bonds described above, TIPS have a composite interest rate based on a fixed and an inflation-adjusted component based on the CPI-U. TIPS are issued in a variety of durations (5, 10 and 30 years). They are sold electronically at TreasuryDirect.gov (non-competitive bids only) or at auction through a bank, broker or dealer.
Unlike Series EE and I savings bonds, an individual investor may purchase almost any dollar amount of TIPS. Non-competitive bids are limited to $5 million per auction, and competitive bids are capped at 35% of a total initial offering amount. The minimum TIPS purchase is $100.
Unlike Series EE and I savings bonds, TIPS have no tax advantages. The interest income produced by TIPS is very tax-inefficient. Therefore it is recommended that savers purchase TIPS in tax-advantaged investment accounts (retirement accounts or similar).
TIPS are extremely popular when inflation is feared. Because TIPS sell at auction, fears of inflation can drive up prices. Thus, when TIPS are popular, savers must pay a premium for TIPS. Competitive bidding involves the services of a third party, which adds another expense to the purchase of TIPS. Corporations as well as individuals can purchase TIPS which makes these instruments even more competitive.
Individual savers can avoid much of the difficulty of owning TIPS by investing in a mutual fund that holds nothing but TIPS (such as the Vanguard Inflation Protected Securities Fund, VIPSX). However, mutual funds must be carefully selected as they add a layer of loads and fees which reduces the returns of this investment.
Overall, TIPS are an outstanding instrument for high-net-worth savers who wish to protect against inflation as well as for any saver who wishes to preserve capital from inflation erosion. Because there are virtually no purchase limits, they are suitable for large holdings and retirement accounts. TIPS are extremely liquid and are backed by the full faith and credit of the United States government.
The humble savings account has some advantages over the Series EE savings bond. First and foremost, cash savings are perfectly liquid. They can be withdrawn at any time without penalty. In a low interest rate environment, savings accounts yield very little but with a little bit of research on a website like bankrate.com savings accounts yielding 2% APY can be found (compared to the current Series EE savings bond yield of 1.2%).
When opening a savings account, a saver should confirm that the bank or credit union holding the account is insured by the FDIC or FCUA (federal agencies that guarantee bank deposits). As of this writing the FDIC/FCUA guarantee limit is $250,000 per account. This FDIC/FCUA insurance means that savings account deposits at participating institutions are guaranteed by the full faith and credit of the United States Government.
Certificates of Deposit (CDs)
Certificates of deposit are savings instruments issued by banks and credit unions. A CD is a time deposit, or an agreement to invest a fixed sum of money for a fixed amount of time. Durations range from one month to five years, with one to two years being standard.
Currently, the average APY on a one-year CD is 1.56% compared to the 1.2% APY of the Series EE savings bond. CD rates vary widely, and at some banks are actually less than the rates on more-liquid savings accounts, so savers should compare rates at www.bankrate.com or a similar website before purchasing a CD.
By definition, CDs are not liquid. The sum should be left on deposit for the fixed duration. However, some CDs include a feature that allows the saver to redeem the CD before the duration is met by paying an interest penalty. Savers should not invest funds in a CD (or, indeed, in any illiquid product) that might be needed in the near future. Not all CDs include this feature, and penalties vary widely, so savers should always understand the features and penalties associated with their CD.
CDs may be purchased online or in person at an issuing bank. There is no limit to the dollar amount that can be invested. The FDIC guarantees amounts up to $250,000, so CD deposits under this amount are guaranteed by the full faith and credit of the United States government.
Treasury Bills and Notes
Extremely large-scale savers, like pension plans and national governments, invest in short-term Treasury bills and notes. These are fixed-duration bonds issued by the United States Department of the Treasury. They are in high demand and very liquid because they are short-term instruments of the highest quality. Treasury bonds are backed by the full faith and credit of the United States government.
Treasury bills are very short-term securities with maturities ranging from a few weeks to one year. Like paper Series EE savings bonds, Treasury bills are sold at a discount from their face value. Upon maturity the saver receives the full amount of the bill’s face value.
Treasury notes have maturities of two, three, five, seven and ten years. Notes are sold at face value and pay interest every six months.
Both Treasury notes and bills may be purchased at TreasuryDirect.gov with the same maximums that apply to TIPS ($5 million noncompetitive bid or 35% of the total issue for competitive bids). Alternately, savers may purchase mutual funds that invest in short-term Treasuries, such as the Vanguard Short-Term Treasury Fund (VFIXS).
Because both types of Treasuries have short durations, they do not carry a great deal of interest rate risk. If interest rates rise, the saver merely holds the Treasuries to maturity and then reinvests the proceeds into the new, higher-rate Treasury.
Each of these alternatives is backed by the full faith and credit of the United States Government. Each of these alternatives is suitable for a different type of saver. In addition, each of these alternatives is easy for an individual saver to invest in. With very little set-up time, any saver can enjoy a variety of alternatives to the Series EE savings bond.