CDs vs. Series I Savings Bonds
What are the advantages or disadvantages of using
I Bonds as opposed to a CD ladder? I know you give up three months
interest on the Series I bonds if you redeem them early, but what
are the other differences? Thank you. -- Finn Fin
Apples and oranges. Both are very safe investments, but the return
on the Series I Savings Bonds will change every six months with
changes in the inflation rate as measured by changes in the Consumer
Price Index (CPI) while the average return on your laddered CD portfolio
changes every time you reinvest a maturing CD.
The idea behind building a CD ladder is to avoid making
bets on where interest rates are heading. You buy a series of CDs
with maturity dates spread out equally over time like rungs in a
ladder. When the shortest term CD matures the proceeds are used
to buy another CD out at your maximum maturity. You'll be "long
and wrong" sometimes and "long and right" at other
times. Overall, you're better off not guessing where rates are heading.
The biggest obstacle in building a CD ladder is getting
past the timing issues when first building one. In stock investing,
dollar cost averaging has investors buying stocks over time by investing
a set dollar amount on a regular basis. When stocks are cheap you
buy more shares, and when stocks are expensive your dollar limit
buys fewer shares. In contrast, a CD ladder is typically built with
an initial investment and the benefits of averaging are realized
when the money is reinvested. An earlier
column has more about building a CD ladder in a low rate environment.
CD rates kept dropping along with
the changes in the Fed Funds rate. It wasn't until the last rate
cut (in June) that longer maturities stopped declining lockstep
with the changes in the short-term rates. The temptation is to build
a "step-ladder" initially and extend the rungs as the
short-term CDs mature.
The Series I Savings Bonds earn interest two different
ways. There's a fixed interest rate component that's determined
at the time that you buy the bond and a variable rate component
that is also set when you first buy the bond but resets every six
months with changes in the CPI. The current (August 2003) fixed
interest rate is 1.10 percent and the variable rate is 3.54 percent.
Combining the two components and converting the result to an annual
percentage yield (APY) has newly purchased Series I bonds yielding
4.66 percent. See the Bureau of Public Debt's Savings
Bond Manual for more information.
Interest earned on U.S. Savings Bonds isn't subject
to state and local income taxes. You can also defer paying federal
income taxes on savings bonds until the bond matures, although that's
not always in your best interest. Savings bonds used to pay for
qualified educational expenses may be free of taxation under the
Bonds for Education program.
A CD ladder will offer some protection against inflation
eroding your purchasing power because long-term CD interest rates
will trend higher with higher inflationary expectations. The Series
I Savings Bonds inflation protection is contractual with rate changes
tied to an inflation index.
As you point out, there's a three-month interest penalty
if you redeem your Series I Savings Bonds within the first five
years. There's also a new requirement for savings bonds purchased
on or after February 2003 that you have to own a savings bond for
at least one year before you can redeem it.
You can only purchase $30,000 of Series I Savings
Bonds in a calendar year. There's no limit on CD purchases but you
do have to be aware of deposit insurance limits imposed by the FDIC
or other depository insurance such as the National
Credit Union Share Insurance Fund.