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Saver’s choice: CD or savings bond?

By Dr. Don Taylor · Bankrate.com
Friday, November 15, 2013
Posted: 10 am ET

I look forward to the semiannual (May/November) release of U.S. savings bond yields by the U.S. Treasury. I'm interested because savers view certificates of deposit and savings bonds as close substitutes. Both guarantee the safety of invested principal. There are some important differences though, including the ability to defer income tax on a savings bond's investment earnings until maturity or redemption, the exemption from state or local income taxes, and the education tax exclusion available when eligible bonds are redeemed to pay qualified higher education expenses.

I've mostly lost interest (pun intended) in the Series EE savings bonds since the change in pricing to a fixed rate in 2005, although it can still be an interesting choice for savers who plan to hold the savings bond for 20 years. While the new Series EE earns a paltry 0.1 percent for the fist 19.5 years of its life, by law it has to double in value in 20 years, which requires a yield of about 3.5 percent. That means that savers get a big "catch-up" interest payment when the bond turns 20. However, what gets me to follow the rate announcements is my desire to see how the Treasury prices the Series I savings bond.

Series I bonds

The Nov. 1, 2013 rate announcement was interesting because it was the first time in more than three years that the Treasury announced it would pay a fixed yield above the inflation rate for the bonds. Series I yields are based on two components: a fixed yield that stays constant over the 30-year life of the savings bond, and a variable yield that changes every six months based on the semiannual inflation rate as measured by the consumer price index. The Nov. 1 announcement has Series I savings bonds purchased between Nov. 1, 2013 and April 30, 2014 earning 1.38 percent for the first six months of the bonds' 30-year life.

I like the comparison of investing in a Series I savings bond for five years with investing in a five-year CD. Why the five-year? Savings bond investors have to own their bond for at least a year, but if they redeem the bond in the first five years, they lose the last three months of interest earnings. It's an interest penalty for early withdrawal, not unlike what a depositor would face on the early withdrawal on a CD. Comparing a five-year CD with a five-year investment in a Series I savings bond puts the two investments in an apples-to-apples comparison since neither investment would face a early withdrawal penalty.

TIPs, CDs and bonds

As I write this, Bankrate's highest yield on a five-year CD is 2.05 percent annual percentage yield. That's a 0.67 percent higher pretax yield than the Series I savings bond. Should a saver with a five-year horizon invest in the CD or the savings bond? Even though the current outlook for inflation is fairly tame, I favor the Series I savings bond. Why? Because of the inflation protection and the guaranteed real yield of 0.2 percent. The five-year Treasury inflation-protected security is currently priced to offer a real yield of -0.7 percent. That's a difference of 0.9 percent in favor of the Series I bond.

Ignoring the tax differential versus the CD, the semiannual inflation rate over the next nine semiannual inflation rate announcements will have to average less than 0.89 percent -- 1.79 annualized -- for savers to be better off buying the five-year CD today. Hindsight won't help with future inflation numbers, but according to the TreasuryDirect website, over the past 32 announcements the average semiannual inflation rate for Series I savings bonds was 1.18 percent.

While inflation, as measured by the CPI, is currently low at an annualized 1.18 percent. I'd take the risk and buy the Series I savings bond versus the five-year CD. No state and local income taxes, the tax deferral option and the option of holding the Series I for up to 25 years past the five-year planning horizon are just gravy in search of a biscuit. (The education tax exclusion isn't something that I expect to use.)

Which investment would you chose over a five-year planning horizon?

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