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Laddering CDs vs. Series I Savings Bonds


Dear Dr. Don,
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

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Dear 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 Savings 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.

-- Posted: Aug. 29, 2003




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