Boring Old Bonds: U.S. Savings Bonds & Treasury Bonds

Filed in archive Investing on August 8, 2006

Other than Gary U.S. Bonds and perhaps James Bonds, there aren't many bonds I find exciting. Nevertheless, I am continuing my series on bonds because it's worth knowing at least a little something about them. (See "The Exciting World of Bonds" if you're as clueless as I was about bonds.)

If we have any knowledge of bonds, most of us think of U.S. Savings Bonds. Several of my relatives bought these for my kids at birth--when the bonds mature, the kids will have a nice little chunk of cash.

So let's start with those.

Paper EE Bonds are the kind that my relatives buy for our kids. They buy at $25 and at the bond's maturity far off in the future it's worth $50. These bonds must be kept at least one year. If redeemed before 5 years, a penalty of three months interest is charged. After 5 years, the bonds can be redeemed penalty-free, but they won't command the full maturity value.

There are also electronic EE bonds, which, if I understand correctly, are bought at face value instead of at a cut rate. I think with these you get paid interest but you are assured that these will reach a certain level at maturity. I'm not really sure why there's a difference there or why you'd buy one over the other--sorry I can't answer that one.

Earnings on these bonds are taxed by the Feds but not by states or localities, unless used for education payments, in which case Federal taxes may go bye-bye as well.

Next are I Bonds, the "I" standing for inflation. (I think.)

I Bonds are bought at face value and they earn interest at a fixed rate PLUS a semiannual inflation rated based on CPI-U. What does that mean? It means there is a fixed, base rate of return on the bonds, plus a variable rate based on the rate of inflation. (CPI-U is the Consumer Price Index-Urban.) So, part of the rate is guaranteed, part fluctuates, but the point is that you're always getting paid beyond the rate of inflation. The same rules from the EE Bonds apply as far as early redemptions, and the same taxation situation as well.

The EE and I Bonds are non-marketable, meaning you can't sell them to anyone else via a bond market. The next bonds--Treasury bills, notes, bonds and TIPS--are marketable, which probably doesn't really mean all that much to you, but it should be mentioned. Also of note: gains on the following bonds are subject to Federal taxes, but not state and local.

Treasury Bills, also known as T-bills, are very short-term securities which can generally be held for as little as 4 weeks or as long as a half-year. When T-bills mature, you get $1000. What you actually pay for the bill depends on how long until its maturity and the interest rate. (For example, you might pay $970 for a $1000 T-bill.) Looking at recent prices, T-bills are giving off a little more than 5% on annual basis.

Treasury Notes are the next step up, as they are held for longer terms--2,3,5 or 10 years. Treasury notes are bought at certain face value and interest accumulates at a fixed rate, every 6 months, until maturity. Your interest rate on a T-Note, as they are called, is not necessarily better than on a T-bill, but by holding for longer, you can lock in an interest rate. If interest rates are going lower, locking in a rate now is more attractive. Obviously it's less attractive if it seems interest rates are going higher.

Treasury Bonds are hardcore -- 30 years until maturity, with interest paid every 6 months until maturity. Again, this allows you to lock in an interest rate. You don't have to hold the bond the whole 30 years -- it can be sold to the highest bidder at auction if you want out. (I won't go into that process here.)

Finally there are TIPS, which I have the hardest time getting my head around. TIPS stands for Treasury Inflation-Protected Securities. It's like the I Bond, in that its goal is to make sure you're earning enough to beat inflation. However, see if you can decipher this:

The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

Not sure exactly what that means. And check out this from Morningstar:

TIPS set their interest rates when they are sold. However, the bond's underlying principal rises and falls with changes in the inflation rate, and as it does so, the amount you'll receive as interest also changes, but at maturity you'll always get at least the par value of the bond.

Riiiight. O.K., this paragraph of Morningstar will scare me off from TIPS once and for all:

Like I-Bonds, TIPS are guaranteed by the U.S. government and are exempt from state and local tax. Unlike I-Bonds, you'll have to pay tax on distributions. Uncle Sam is going to tax you at ordinary income rates for the semiannual interest payments you receive, as well as on the "phantom income" you receive as your underlying principal adjusts for inflation. You won't actually get this inflated principal until the bond is redeemed, but you'll be paying tax on the adjustments annually. If that tax is significant, you could find yourself in a negative cash flow situation--more is going out in tax payments than is coming in through interest payments.

For those reasons, TIPS are most often recommended for tax-deferred accounts.

But consider this: If you put TIPS in most tax-deferred accounts (not Roth IRAs), they'll lose their state and local tax-exempt status. That's because when you eventually take securities out of most tax-deferred vehicles, they're taxed at ordinary income-tax rates at federal, state, and local levels. So, for investors in lower tax brackets, especially those who live in a state with high tax rates, TIPS may make sense in a taxable account or Roth IRA.

Whatever... Bottom line IMHO: TIPS are a pain in the ass and not worth your time.

Whew, I'm glad that's over. Unfortunately that covers the Federal bonds but there are other types I'll discuss when I get a second wind.