Back to Basics: Savings Bonds

As we near back-to-school time, we’re going to embark on a short series of investor refresher courses. Let’s start with savings bonds, the Pythagorean Theorum of investment choices: simple, easy to learn, and tried and true.

Savings bonds are US government debt obligations. They are non-negotiable securities backed by the Treasury Department that pay an interest rate that is compounded semiannually and accrued monthly.

There are better, more interesting investments than savings bonds. In fact, many experts consider savings bonds only a savings vehicle as opposed to an investment vehicle, and with good reason: they simply do not offer the growth potential of other investments. And while they are among the safest “investment” vehicles, that doesn’t mean they don’t have risk. Savings bonds offer inflationary risk—the risk that inflation makes the initial investment less valuable over time.

But savings bonds have some advantages that other vehicles don’t offer, and for that reason they still bear some consideration, not as the foundation of an investing strategy, but as a corollary.

Let’s talk through some of the advantages of savings bonds. (Note: there are many different types of bond offerings, so the information below is slightly generalized.)

Some Advantages in Safety

If you’re a regular reader of Dentist’s Money Digest, by now you’re familiar with the inverse relationship between risk and return. The fact that savings bonds are backed by the federal government makes them among the safest investments available. But that doesn’t mean they are completely without return. The US government offers interest rates that are competitive with the market. Some bonds are even available that adjust for inflation.

Monthly interest compounding is rarely offered in corporate bonds, which typically make interest payments twice per year. While the interest that is compounding with savings bonds won’t be huge given their safety, compound interest does add up over time.

Beyond safety, savings bonds offer convenience, because they are issued in different denominations starting as low as $50 and up to $10,000. That can be attractive for investors who have large sums of money locked up in other investments. Savings bonds are somewhat liquid; although they can’t be bought or sold on the open market like a stock or a corporate bond, you can redeem them at most banks whether you are a customer of that bank or not. Keep in mind that redeeming bonds early can come with some penalties. Savings bonds generally bring a low tax liability, as the interest income earned is subject to federal income taxes but not state or local income taxes.

Like all investments, savings bonds have their cons as well, but it isn’t a long or dangerous list. As mentioned above, redeeming before a waiting period will result in some (relatively) mild penalties. Also, when redeeming, you should be aware of when the next interest payment is posted so that you don’t miss out on that extra income by only a few days.

Savings bonds are vanilla by design, but like their counterpart in ice cream, they can be a welcome addition to some fancier choices.