How to get More Bang for Your Buck

By Justus B. Morgan and Michael P. Haubrich, CFP

August 2003

If you’re like most people in today’s low interest rate environment, your money market account is earning a paltry 1.3% or less. What would you say if we told you it was possible to earn more than three times as much interest risk-free? If you think it sounds too good to be true perhaps its time to revisit an old investment standby, the U.S. savings bond.

Savings bonds have been around since the 1940’s when they were used to help finance World War II. Today there are two popular versions, the Series EE and I. The Series EE savings bonds are the direct descendent of the original Series E. Today their interest rate is 90% of the average 5-year Treasury securities’ yields for the preceding six months. This translates to 2.66% for the six months ending November 1^st. Series I are the newest savings bonds and were first introduced in 1998. Their interest rate has two components. The fixed component is determined when the bond is issued. The variable component is tied to inflation, hence the I in the name. The variable component changes every six months and the bond currently earns 4.66%. Series EE and Series I savings bonds earn interest for up to thirty years which means for those of you with bonds dated before August 1973, it’s time to cash them in.

In addition to their competitive yields, savings bonds also offer some unique tax advantages. First, unlike other Treasury securities, savings bonds are an accrual-type security which means interest and income taxes are only paid when the bonds are cashed in. Second, the interest earned is exempt from state and local taxes. Finally, depending on income levels, savings bonds can also be used towards college tuition expenses with no income tax on the accumulated earnings.

You may ask why haven’t you been told about this opportunity before? First, there’s no incentive for financial advisors to tell their clients about savings bonds. Savings bonds do not pay any commission to brokers. In fact, there are no fees at all for investors to buy or sell savings bonds. Second, banks are not excited about seeing money move from their CDs and other investment products to savings bonds. According to the bank industry’s trade magazine, American Banker, banks receive $0.50 from the U.S. Treasury for selling each paper-based order of savings bonds and $0.30 for redeeming savings bonds. Compare this to the fees they earn on some of their commission-based investment products and it’s no surprise banks aren’t promoting savings bonds. To make matters worse, the Treasury Department has proposed eliminating its savings bonds marketing and investor education program on October 1, 2003. If you thought you didn’t hear much before, wait until October and you’ll hear even less!

In today’s market environment, safety is a major concern for both large and small investors. Savings bonds help fill this gap because they are backed by the full faith and credit of the U.S. government. In addition, unlike regular treasury notes, there is no interest rate price risk which means the price of a savings bond will not decreases as interest rates rise. You will never have to sell a savings bond for less than what you paid nor will the appreciated value ever decrease. If an investor buys Series I savings bonds, the risk of inflation is also mitigated because the interest rate on the bond will increase as inflation increases.

The major drawback with savings bonds is they must be held for at least one year, the minimum holding period. After this time, savings bonds can be redeemed any time although there is a three-month interest reduction for redemptions within five years of the purchase date.

We’ve developed a strategy to take advantage of today’s low interest rate environment to leverage the tax laws to client’s advantage. By refinancing a mortgage at today’s low interest rates and using the proceeds to purchase savings bonds, an investor can reap a number of benefits. By using the extra cash from the refinance to buy savings bonds earning more than the mortgage rate, investors are able to earn more interest than they pay. In addition, the interest on the mortgage is tax deductible in the year it was paid while the interest earned on the savings bonds is tax deferred until the savings bonds are redeemed up to thirty years later or longer. You have also pulled equity out of your house providing extra liquidity in case of an emergency. Remember the old adage, “it’s easier to put money into real estate than it is to get it out!”

There are four possible outcomes of using this strategy. First, you could decide you don’t like the extra mortgage amount. In this case you’d redeem the savings bonds after one year and pay off the mortgage pocketing the extra interest you earned. Second, interest rates could remain the same. In this case you’d keep your money invested and reap the benefits of investing in savings bonds. Third, interest rates could go up in which case your cost of borrowing remains fixed while the interest rate on your savings bond increases, resulting in more profits. Fourth, interest rates could continue to decline to record lows, decreasing the interest rate on your savings bond further. This would also allow you to refinance your mortgage again to capture the lower rates and position yourself for when they eventually rise. It’s not unheard of for people to refinance two or three times per year as interest rates drop. In any of the above scenarios, you, the savvy investor, come out ahead.

There are a number of ways to purchase savings bonds today. You can go to any local bank and order savings bonds in denominations between $50 and $10,000. Many employers offer payroll deductions that allow you to purchase savings bonds directly with your paycheck. Our favorite method for purchasing savings bonds is online through Savings Bonds Direct. This method allows you to purchase savings bonds with your credit card. The advantage of this route is it allows you to earn premiums on your credit card because the purchase is treated as a merchandise transaction. For instance, if you have an airline-affiliated credit card and purchase $25,000 worth of savings bonds, you just earned yourself a free ticket. Of course we also recommend you pay the balance on your credit card immediately as interest payments on your credit card can negate the benefit of using it to purchase savings bonds.

If you’d like to learn more about savings bonds or how to purchase them online, visit their website at http://www.savingsbonds.gov. If you’d like to learn more about the strategies behind using savings bonds in your investment portfolio contact us.

Justus Morgan is currently enrolled in the Master of Business Administration program at Marquette University. Michael Haubrich, CFP, is president of Financial Service Group, Inc., a registered investment advisory firm in Racine, website address www.toyourwealth.com.