Big drop in Series HH savings bond interest rate
By Laura Bruce • Bankrate.com

With one big slash, the Treasury department cut the interest rate on the Series HH savings bond to 1.5 percent from 4 percent for bonds issued on or after Jan. 1, 2003. A stunning change made, according to a news release, "to better align the effective return on savings bonds with marketable security yields."

Series HH bonds can't be bought directly; you can get them only in exchange for Series E or EE bonds that have been held for at least a year, or if you're reinvesting the proceeds from matured series H bonds.

Dan Pederson, president of BondHelp.com and author of Savings Bonds: When to Hold, When to Fold, and Everything In Between, says the new rate corresponds to rates for three-month or six-month Treasury bills, but that the government should have pegged the HH, a 10-year bond that can be rolled over for a second 10 years, to the five-year or 10-year notes which pay 3.5 percent and 4 percent, respectively.

"The cut from 4 percent to 1.5 percent is a 62.5 percent drop in the interest rate, and it falls mainly on the backs of older Americans," says Pederson. "They're the folks who generally would have held E or EE bonds for quite a period of time. They're also the ones who are most likely living on fixed income.

"A person that had $100,000 in HH bonds and was used to getting $4,000 or $6,000 -- some are still out at 6 percent -- is now dropping to $1,500 a year."

Pete Hollenbach, spokesman for the Treasury's Bureau of Public Debt, says the HH shouldn't be equated with a 10-year note where you're assuming market risk.

"You have a bill you can redeem at any time after holding it for six months. If I have an HH now, I get 1.5 percent for six months. How does that look vs. other returns I can get on investments that don't have any market risks?

"The other key thing is the primary reason a lot of people exchanged for HH, especially at the 4 percent rate, was to defer taxes on the interest they earned on the E or EE bond they held. You have to look at the whole package. You have the tax deferral and a security you can redeem any time after six months."

Older-bond holders in for a shock
The interest rate cut will be especially devastating for people who bought HH bonds prior to March 1993 when the rate was at 6 percent. The rate on HH bonds is reset every 10 years, so most of those 6 percent bonds would have dropped to 4 percent before going to 1.5. But bonds purchased in February 1993 will plummet from 6 percent to 1.5 percent in February 2003.

Pederson says he thinks the big drop may be an indication the government is considering getting rid of the HH down the road. Clearly, not many investors will be clamoring for a 10-year bond that carries a 1.5 percent interest rate.

"It's cheaper to raise money through marketable Treasury securities than through savings bonds. It's already in a book-entry system, so they don't have the issuing of paper in and out," Pederson says.

"Also, the minimum purchase is $1,000. If I could give you two clients with $1 million each or 2,000 clients with $1000 each, you'd rather have the two clients. All those other people have $50 and $100 bonds. I have to maintain a database; replace bonds when they get lost, etc. In the end I'm getting the same money for less work."

Hollenbach says no final decision has been made on eliminating the HH but that the government is gearing up for switching the bond program from paper to electronic.

Pederson cautions people who may be a couple years away from retirement to think twice before cashing HH bonds because of the skimpy new rate.

"If you get out of an existing HH, or get out of an E or EE and don't roll them over, you have to consider the taxable event.

"If you're two years from retirement and need tax deferral for a couple years, you may just want to swallow the 1.5 percent. Say your income tax rate drops from 27 percent to 15 percent. By waiting two years, on $10,000 worth of interest you'll save $1,200 in taxes."

-- Posted: Jan. 20, 2003