Friday, July 30, 2010

Plusses and Minuses of I Savings Bonds, Part II

So far in this group of posts on savings bonds we have covered the now defunct Series E bonds, the basics of Series EE Bonds, the basics of Series I Bonds, how to buy and sell savings bonds, two posts comparing Series EE savings bonds with Certificates of Deposit (CDs) and Treasury bills and notes and the first half of an analysis comparing Series I bonds to TIPs.[Link here]

Here’s the remainder of that discussion:

Rates of return: TIPs that mature in about five years currently yield 0.5%., a slightly higher return than the current 0.4% real interest rate on Series I savings bonds. If we increase the maturity to 10 years, the yield on TIPs rises to 1.2%—significantly higher than you get with the current Series I bond. At 20 years (actually closer to 18.5 years given the outstanding TIP issues) the TIP yield is up to almost 1.9%. That rate remains essentially flat for bonds up to the longest outstanding TIP (not quite 30 years).

Taxes: Taxation: How savings bonds interest is taxed has been discussed in previous posts.

Both the interest and increased principal from TIPs are taxed in the year earned. Every six months you will receive the interest payments but not the increase in principal. Consequently, you must pay taxes on the increased principal from other funds. Taxation of the earned, but not yet received, principal increase is one reason most people choose to own TIPs in their IRAs rather than in taxable accounts.

In the previous post I discussed the general advantages of deferring taxes, but in summary, although tax-deferral is an advantage of savings bonds, at today’s interest rates, and assuming constant tax rates, the effective rate of return on Treasuries is greater than Series I bonds and overwhelms the Series I tax-deferral advantage.

Conclusion: Again, there is no simple one-size-fits-all answer. Compared to TIPs, Series I bonds have three significant advantages: they are simpler to buy and redeem; you can buy them with as little as $25; in case of deflation, they provide more value than TIPs.

If you really think deflation is going to be the norm during the period you expect to hold your bond, then you should buy neither TIPs nor Series I bonds. Hie thee to the treasury market and buy a Treasury Strip of your desired duration.

Unless you are not planning to hold your purchase for a few years, the extra yield on TIPs seems to me to be worth the added aggravation (which isn’t much with TreasuryDirect®) of buying TIPs online provided (1) you can take accept the swings in market value TIPs endure, (2) you don’t plan on selling before maturity (or have the financial resources to handle a capital loss, and (3) you are purchasing at least $1,000 worth of securities.


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