Best Bond Investments Today

For about a year now interest rates across all types and maturities of bonds have been pitifully low. They are a result of newly-found (post-2008 crash) risk aversion in investors, subdued expectations for future growth (which might have made stocks more enticing than bonds), and, of course, actions of the US Federal Reserve and other central banks around the world aimed to spur growth by simultaneously making it cheaper to loan money (which leads to consumption, investment, and hopefully growth) and less attractive to save it.

Puzzlingly, to me, that last reason for low interest rates -- the actions of central bankers -- seemed to have created millions of instant monetary policy experts all around the blogosphere and the media. I would like to assure you that none of them have a clue -- though they sure do have strong opinions. Not that I have a clue either. And I suspect that the central bankers themselves realize how little solid evidence they have for making decisions one way or another -- which is a polite way of saying they know they don't really have much of a clue either.

What I do have a clue about is how to make the most of today's low interest rates without taking undue risk. Not so long ago I recommended municipal bonds, and especially corporate bonds, as alternatives to US treasury bonds: http://www.longtermreturns.com/2012/03/municipal-bonds-treasuries-corporate.html and http://www.longtermreturns.com/2012/03/q-corporate-bonds-or-us-treasuries.html (I made other posts about this subject if you are interested in searching for them). Since I recommended them those bonds have enjoyed very nice returns and most of those recommendations still very much apply today. Barring absolutely unprecedented economic calamities -- worse than the 2008 meltdown and worse than Great Depression -- corporate bonds and likely municipal bonds as well will deliver higher returns than the US treasury bonds when held to maturity.

However what corporates will not deliver is treasuries-level safety should a new crisis strike or existing crises intensify significantly -- however unlikely those events may be. For many investors this risk is enough to write off corporates and stick entirely to treasuries. It's not an irrational approach if you are risk-averse enough. So today I would like to focus on alternatives that actually exceed both the returns and the safety of the US Treasuries! They are also issued by the US Treasury and are called US Savings Bonds, specifically I Savings Bonds and EE Savings Bonds. They are almost certainly a far better deal today than any "conventional" US Treasury bond or bill of the type found in fixed income mutual funds. While there are some fairly far-fetched scenarios under which conventional treasuries might do better, I and EE Savings Bonds will do better in any "normal" scenario and could easily do much better if the economic conditions improve and interest rates rise. I do want to emphasize that neither I nor EE bonds are great deals in absolute sense -- there are no great deals in absolute sense in today's fixed income markets. But I and EE Savings Bonds are far better than "conventional" US treasuries and arguably better than corporate or municipal bonds as well, due to their unparalleled safety, both from credit risk and from interest rate risk.

I Savings Bonds

I Savings Bonds are close relative of TIPS. TIPS offered some very reasonable deals as recently as a year and a half ago when I recommended buying 30-year 2% TIPS. If you followed my recommendation then you'd be sitting on nearly 50% gains right now! Not that I expected anything close to that at the time -- I was merely recommending what I saw as a reasonable and guaranteed long-term investment. In any case, those days are long gone. Today's TIPS are quite pricey, with 5-years priced to deliver full 1.5% below inflation, 20-years to just break even with inflation, and only 30-years to deliver rather measly 0.4% above inflation. Enter I Savings Bonds. They are guaranteed to match inflation plus return a fixed rate beyond it. Right now that fixed rate is zero, meaning the I Savings Bonds will exactly match inflation and nothing else. Doesn't sound that great, right? And it's not. But compared to TIPS they are still a wonderful deal for a number of reasons:

• As I just stated, all the way to 20-year maturities TIPS will not even provide the inflation-matching of the I Savings Bonds. At shorter maturities I Bonds will outperform TIPS by very generous 1.5% per year.
• Why not just buy 30-year TIPS then and "beat" I Savings Bonds by 0.40%? Because unless the current economic malaise will be with us for decades -- which is possible but hardly likely -- the interest rates will rise sooner or later, almost certainly on all types of bonds and all maturities. When that happens the longest-maturity bonds, like the 30-year TIPS, will be hit the hardest. Just as they gained nearly 50% since my recommendation of them so they could easily lose 30% in a reverse move! It's true that they will eventually recover those losses as they reach maturity in 30 years but that's a long time to wait all the while missing out opportunities to invest in newer bonds at higher yields. I Savings Bonds don't have this problem. They are safe from any declines and can be redeemed in as little as one year for a small penalty (3 months' interest) or in five years with no penalty at all. Invest in today's I Savings Bonds, handily beat out shorter-maturity TIPS to the tune of ~1.5% per year, and when the interest rates rise, redeem them at full face value plus accumulated interest and re-invest into new bonds with higher maturities (after, granted, paying taxes).
• On top of the above advantages you can defer paying taxes on I Savings Bonds for 30 years or till redemption. As I never tire or repeating, deferring taxes is a huge deal in investing (though it's true that it becomes more important at higher rates of returns than available from bonds today)

To summarize, I Savings Bonds will beat today's short-ish term TIPS on yield all the way to 20 years and will absolutely crush long-term TIPS when the interest rates finally rise because they can be redeemed (nearly) penalty-free at full value plus interest while long-term TIPS get pummeled in the interest rate rise. The only way you can "lose" on I Savings Bonds is by 0.4% annually if the interest rates never rise for the next 30 years! That is an awfully unlikely scenario. But wait, there's more! Even in that last scenario I Savings Bonds will likely still beat TIPS in taxable accounts because I Savings Bonds can grow tax-deferred while TIPS would hit you with full taxes both on the measly interest they pay out plus the inflation adjustment which is not paid out but increases the principal. There is simply no way that you can lose with I Savings Bonds compared to TIPS.

The only caveat is that I Savings Bonds are only available capped at $10,000 per year per Social Security number from treasurydirect.gov. Another $5,000 can be purchased in paper form as result of tax refund. Still, that's up to $30,000 per year that a married couple can sock away (and more if they have children) in an essentically zero-risk vehicle that's nearly guaranteed to handily beat apples-to-apples alternatives.

EE Savings Bonds

EE Savings Bonds aren't quite as attractive as I Savings Bonds in my estimation, but still easily beat their equivalent "conventional" US Treasury bonds. EE Savings Bonds are not indexed for inflation. They simply have a set fixed interest rate that happens to be putrid 0.60% today. So why am I recommending them? Because they have a clause of guaranteed doubling in value after 20 years! That means on its 20-year anniversary your  EE Savings Bond will get a one-time adjustment that will be the equivalent of having about 3.5% interest rate all along. 3.5% doesn't sound like anything great to wait for 20 years to materialize until you realize that equivalent 20-year US Treasury bond will only yield 2.5% today! EE Savings Bond will be beating it by a full percent annually! Even the 30-year US Treasury only yields 2.9%.

On top of the obvious yield advantage once you get to 20 year age, EE Savings Bonds enjoy the same tax deferral properties as I Savings Bonds, and, importantly, the same early redemption ability. Should rates rise before the 20 years are up you'll be able to cash in your EE Savings bonds, collect your not-so-spectacular 0.60% interest but also full face value, pay what little taxes you owe (won't be much with 0.60% interest), and immediately re-invest into higher-yielding bonds. Compare that to taking a 10-20-30% hit on long-term nominal treasuries. Not so bad!

As with I Savings Bonds you can buy up to $10,000 in EE Savings Bonds per year per Social Security number (there is no option to use tax refund to purchase additional EE Savings Bonds)

Conclusion

Today's I and EE Savings Bonds deliver higher yield than other US Treasury bonds while providing equivalent safety from default and far better safety from interest rate risk (rising interest rates). They don't have quite the same edge in yield on corporate bonds, but they far exceed them in safety. In short, they are the sweet spot of bond investing today. This is a very rare "free lunch" that you would do well to take advantage of -- especially if you have to invest in bonds in taxable accounts. And remember to keep an eye out for when interest rates finally rise to the point where it makes sense to redeem your I and EE Savings bonds and re-invest the proceeds into higher-yielding vehicles.