Here's Why You Might Buy Both I Bonds And EE Bonds (2024)

They make a wonderful barbell.

I'll get back to that later. But first, let me again thank Tipswatch for another excellent article with a solid, ultra conservative, and actionable suggestion. The essence of his article was that EE savings bonds may offer a good deal, especially for safe retirement income (particularly if you anticipate a low tax rate). They are also a wonderful vehicle for funding higher education for a dependent, in which case, there are no taxes at all.

It might be a good idea to act before May 1, however. May 1 is this Sunday, by the way. There is a possibility that the terms may be altered to a slightly less favorable deal. It's unlikely, but it has happened in the past.

I will recapitulate the facts mentioned by Tipswatch and try to add a couple of wrinkles of my own.

How EE Bonds Work

At first glance, EE Bonds don't provide anything spectacular. They currently pay .1% fixed interest, the same as I Bonds. I Bonds, of course, also pay a variable adjustment, the Urban CP!, calculated twice annually and upgrading each May 1 and November 1. I already bought my I Bond limit for the year ($10,000). I wrote about I Bonds in this article, which you should read if considering them.

As compensation for the absence of an inflation adjustment kicker, EE Bonds have an unusual feature. They pay only the .1% annually throughout their 30-year life, but after 20 years, they reset at double the amount of the investment. If you buy the $10,000 limit, the value jumps after exactly 20 years to $20,000. In this case, the yield suddenly becomes roughly 3.5%, internally compounded and not taxable for 20 years (nor ever under the stated conditions if used for higher education).

With the addition of this provision, EE bonds become a pretty darned good deal. The catch is that you have to be very certain you want to hold them for 20 years. The rational procedure is to hold them for exactly 20 years, accept the doubling of value, then sell and move on that very day, or close to it.

If you do that, you will beat the currently available safe return of that duration of Treasuries - about 2.3% going 20 years out. You will also beat the return on I Bonds over that period if the average inflation rate stays under 3.5%. That's a reasonable bet. You don't, of course, get the powerful assurance given by I Bonds and TIPS against a significant increase of inflation over 30 years.

I believe the way to think about EE bonds is as the savings bond equivalent of zero coupon bonds. They compound internally and pay basically the full amount all at once. They don't, of course, have the price change quoted daily in the markets for zeroes - the effect of decreasing distance to maturity and changes in the prevailing interest rate. On the other hand, they don't have the problem of Original Issue Discount (OID) annual taxation on phantom (non-cash) income that zeroes have. That's the tradeoff to weigh when comparing EE Bonds to 20-year Zero Coupon Bonds.

There Could Well Be Some Opportunity Cost

One thing to bear in mind is that as the years go by, you will find yourself increasingly locked into the 20-year duration. For the first year or two, they will work the same way as I Bonds, even better in the event of deflation. I Bonds earn more immediately because of the inflation adjustment, but deflation can eat into their current .1% fixed rate. This is not the case with EE Bonds. For all practical purposes, both savings bond vehicles are reasonably competitive with what you can get for money languishing in a bank or money market account if you are pretty sure you are willing to wait at least a year to get your money out.

But here's an oddity. The prospective rate to the 100% jump changes as the years pass. After 6 years, it is about 5%; after 8 years, 6%; after 10 years, 7%. After 13 years, it's 10%. Pretty soon, you're talking about real money. At the end of the 19th year, your return to maturity is 100% for the next year. Well, I put in that number just for fun (it's true, though), but it's obvious that you will be increasingly locked in even if you suddenly need cash.

If rates change and you feel you could do better - a fairly likely possibility - you would probably find that selling your EE Bonds prematurely involved too great a sacrifice. They need to be looked at as a quirky part of an overall bond portfolio having their own special characteristics. For mechanical flexibility, you would prefer a bond ladder, which turns over every couple of years.

That being said...

Consider The Barbell Approach

Many fixed income advisors currently favor an intermediate term approach to bond investment. Their rationale is that rates are currently terrible, so the best approach is to get whatever is available beginning at the duration where there is any meaningful return at all but structured as a ladder or laddered fund going out a few more years. The portfolio then turns over as time passes, so that if rates begin to rise, your shortest duration (and poorest return) bonds will be running off the book and getting replaced by bonds a step beyond your longest duration - hopefully, at an improved amount because of rising rates.

There is nothing wrong with this approach. It's conservative and logical. It's a way of getting some return and not getting trapped if rates surge. The trouble is, remember, you have to go out 20 years with Treasuries to get a measly 2.3%.

There's another way to think about it, however: the barbell. A barbell is a portfolio concentrated at the two ends instead of the middle - thus the term barbell. You buy both the very short end and the long end. It's the exact opposite of sticking to intermediate durations. And let me say clearly: I wouldn't think of it if the long end paid just 2.3%.

EE Bonds, however, offer 3.5% for those willing to stick with them for 20 years. That's a good bit closer to the long-term Treasury average. For significant periods in the past, Treasury long bond yields have hovered around that number. If they should blast off and go up, on the other hand, you have all that very short-term money to throw at them.

As I said in my earlier piece, I Bonds provide a very good parking place for short-term money, under most circ*mstances quite a bit better than EE Bonds or most ultra safe short-term competition.

I Bonds and EE Bonds together? That may provide an interesting and rather elegant barbell. The inflation kicker of I Bonds is sort of gravy, getting your ultra short return up a bit.

Conclusion

That's my thought then. It's not necessarily I Bonds or EE Bonds. It may well be I Bonds and EE Bonds. You have a natural barbell, but with a likely 1.5% or so yield advantage over Treasury Bills/Notes coupled with 20-year bonds. You are rigidly committed to the long end, but at a decent rate, and have wonderful flexibility at the short end.

The EE Bond strategy works to perfection, by the way, as a gift to a newborn, or to children in the first two or three years of life. As to myself, I expect to cash them late in my retirement and pay my taxes but if I should step in front of a bus, my children, and before long, great-grandchildren, would be happy for the benefit of them.

For both I Bonds and EE Bonds remember: possibly better before May 1. That's Sunday.