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Attractive alternatives to savings bonds available

Greg McBrideInvestors in Series EE savings bonds will earn a fixed rate of return for any bonds purchased after May 1. While the prospect of earning a fixed rate will be very attractive once interest rates peak or begin to decline, locking in a fixed rate for the long haul is not advisable in a rising rate environment. Fortunately, the highest-yielding bank money market accounts, savings accounts and certificates of deposit make suitable alternatives when the Series EE savings bonds lose their luster next month.

A new rate for Series EE savings bonds will be announced at the beginning of May, and bonds issued after May 1 will earn that rate for the next 20 years. Only currently outstanding EE bonds will continue to earn a floating rate of interest. For further insight into why the Treasury has made this change, and the timing of the change, see Bankrate's article, "Savings bond buyers may be offered a lousy deal," by Laura Bruce.

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Investors looking for competitive returns on a safe investment have other places to turn. Money market deposit accounts (MMAs) and savings accounts currently offer yields as high as 3.3 percent with no minimum deposit. Unlike savings bonds, there is no minimum holding period. Both the Series EE and Series I bonds require investors to hold the investment for one year before it can be cashed. Even then, a penalty of three months' interest is assessed for any bond cashed within the first five years.

MMAs and savings accounts also offer something that the EE bonds issued next month will not -- the ability to benefit from rising interest rates. The returns earned on the top-yielding money market and savings accounts are poised to increase further as the Federal Reserve continues to raise interest rates. As of Dec. 7, the highest-yielding, nationally available bank money market account earned 2.3 percent, a full percentage point below the current yield.

For investors willing and able to commit cash for some length of time, as is required when buying savings bonds, the highest-yielding CDs are a great alternative. With the highest-yielding CDs, investors earn returns high enough to compensate for the lack of exemption from local and state taxes that savings bonds offer. Investors also gain the flexibility to tailor CD maturities for access to cash when it is needed and the ability to reinvest in new CDs at higher returns.

For example, on a $1,000 investment, a one-year CD yields as much as 3.97 percent. Twelve months from now when the CD matures, the investor can either spend the cash -- $1,039.70 assuming all interest is reinvested -- or reinvest in another CD that is expected to be offering higher returns than are now available.

While the fixed rate earned on an EE bond purchased next month won't be known until the beginning of May, one thing is certain. One year later, the investor would forfeit the final three months of interest earnings if he or she wished to cash the bond. For someone in that situation, the EE bond will, in effect, pay an as yet undetermined rate from May 2005 through January 2006, and nothing at all from February through April of next year. For an investor not subject to local or state taxes, the EE would need to pay a fixed return of 5.3 percent in order to be the better alternative over that period.

Over a two-year horizon, the highest-yielding CD of 4.3 percent would also set the bar high for EE bonds. The EE bond would need to pay a fixed rate of 4.9 percent beginning May 1 in order to give the investor the same return after the forfeiture of three months of interest.

But what about the ability to defer federal taxes on the savings bond, you ask. With savings bonds, investors defer any federal taxes until the bond is cashed, unlike interest earned on a CD held in a taxable account. This interest is taxable in the year it is earned regardless of whether the investor received the interest payment or had it reinvested. Over such a short time horizon, this deferral does not amount to a significant difference. For a much longer time period, where this deferral really has legs, earning a below-market fixed rate on the EE bond will more than negate that benefit.

The inflation indexed I bond is a poor alternative, as it guarantees the investor a scant 1-percent fixed rate of return after inflation. By comparison, if inflation remains below 2.9 percent over the next year, the investor earns a higher after-inflation return on a one-year CD. The Treasury can always change this fixed return on May 1, as they've slashed this return from as high as 3.6 percent in 2000. But don't hold your breath for any significant upward revision.

The appeal of savings bonds has been stripped away through a series of Treasury announcements in recent years. Not to worry, however. Investors will get greater flexibility with a combination of liquid money market or savings accounts and CDs, without having to sacrifice yield.

-- Posted: April 18, 2005




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