EE Bonds Versus Other Long-Term Bonds

Yet another post on why I feel that EE Savings Bonds are currently preferable to any other long-term bond investments... Before I proceed with EE-Bond discussion, remember that I Savings Bonds are an even easier decision than EE-Bonds since I-Bonds don't require the 20-year commitment that EE-Bonds do and readily double as "high-yield" tax-sheltered emergency fund. But that's all you'll read about I-Bonds in this post...

EE-Bonds Versus Long-Term US Treasuries

This one is very simple. 20-Year US Treasuries, which equal EE-Bonds most relevant maturity point, have yield to maturity of about 2.4% versus EE-Bonds' 3.5%. Today's 30-Year US Treasuries, which roughly equal EE-Bonds duration (remember that today's EE-Bonds are most easily thought of as a zero-coupon bond with 20-year maturity and, therefore, 20-year duration) have yield to maturity of about 2.9% versus, again, EE-Bonds' 3.5%. Whatever you wish to choose as point of comparison among long-term US treasuries, EE-Bonds easily come out on top in yield to maturity. And this is before we consider EE-Bonds deferred taxation and their built-in put option which might prove very valuable in interest rates rise significantly in the next few years.

EE-Bonds Versus Long-Term Investment Grade Corporate Bonds

The comparison against corporates is not quite as cut-and-dry, but EE-Bonds still come out on top. Vanguard's long-term corporate bond funds have maturity of more than 20 years and duration of less than 20 years which, to me, makes them a sufficiently apples-to-apples comparison with the 20-year maturity/duration EE-Bonds. From http://www.longtermreturns.com/2012/03/q-corporate-bonds-or-us-treasuries.html we know that historically 20-year cumulative (not annual!) default rates on corporate bonds have averaged:

• 1.7% for Aaa
• 5.3% for Aa
• 6.8% for A
• 13.2% for Baa (which the lowest investment-grade rating)

Vanguard's slightly-higher-quality long-term corporate bond fund VWESX/VWETX (VWETX is the Admiral version) has SEC yield of about 4.0% and portfolio mix of about:

• 4% Aaa
• 16% Aa
• 55%% A
• 25% Baa

Assuming the next 20 years bring us historically average corporate default rates we'd expect cumulative defaults of about 7.9% which works out to about 0.4% annually. Subtracting that from headline SEC yield we get expected return of 3.6% from this fund.

Vanguard's slightly-lower-quality long-term corporate bond ETF VCLT has SEC yield of about 4.3% and portfolio mix of about:

• 1% Aaa
• 7% Aa
• 46% A
• 46% Baa

Assuming the next 20 years bring us historically average corporate default rates we'd expect cumulative defaults of about 9.6% which works out to about 0.5% annually.  Subtracting that from headline SEC yield we get expected return of 3.8% from this fund.

As a reminder, expected annual return on EE-Bonds over 20 years is slightly above 3.5% (2 ^ (1/20) - 1 if you like math) which is almost in line with VWESX/VWETX and slightly lower than VCLT. But what you get in return is best available protection in case the next 20 years turn out to be worse than average as far as default rates go, as well as deferred taxation and that same potentially very valuable put option to redeem EE-Bonds at more-or-less (actually a hair higher than) principal value should interest rates unexpectedly rise soon. To me those characteristics are more than worth the tiny relative difference in expected returns. To be fair historically corporate bonds recovered about half of their value even in defaults, but that extra 0.2% annually does not change the picture substantially for me.

EE-Bonds Versus Long-Term Municipal Bonds

Vanguard's "long-term" municipal bond funds have maturity and duration of well under 10 years which means that they are not suitable for an apples-to-apples comparison against EE-Bonds. However several other companies, including PIMCO, Invesco PowerShares, and State Street offer so-called "Build America Bonds" (BAB) ETFs which can be thought of as taxable municipal bonds and which, conveniently for our analysis, offer maturities and durations similar to those of Vanguard's long-term corporate bond funds: maturities of over 20 years and durations of under 20 years. This makes BAB ETFs suitable for a comparison with EE-Bonds.

BAB ETFs vary in their composition, but generally have slightly higher credit ratings than long-term corporates: something like 10% Aaa, 45% Aa, and 45% A. Historical default rates for municipals have been lower than for similarly rated corporates, so we'll somewhat generously assume zero losses due to defaults on our BAB ETFs. Their SEC yields are about 4.0%. Those characteristics combined make BAB ETFs toughest competition yet to our EE-Bonds. The question becomes whether the approximately 0.5% in extra yield of BAB ETFs is enough to overcome the extra perks of EE-Bonds. In taxable accounts the answer would be a pretty clear "no" (since, remember, BABs interest is taxable). But in tax-sheltered accounts you could make a case for them. Personally though, I would forego that 0.5% extra and go with EE-Bonds for their ultimate safety and to save the tax-sheltered room for other investments. I might lose a tiny bit relative to BABs in the most BAB-friendly scenario but can come out quite a bit ahead in BAB-adverse ones.

The above choice is underscored by the yields available from truly safe munis: 2.75% on 30-year Aaa as can be seen at http://www.bloomberg.com/markets/rates-bonds/government-bonds/us . Note that now we're talking about tax-exempt municipal bonds. Still, a 30-year 2.75% has duration of slightly longer than 20 years (and obviously a 30-year maturity), but would still lose to the after-tax rate on today 20-year EE-Bond for up to 28% tax bracket. And this is again, not counting the considerable value of EE's built-in put option.

Conclusion

Hopefully the above comparisons make it clear why I view today's EE-Bonds as best available long-term fixed income choice. In no way are they bargains in absolute terms, but they are your best available option if you want to hold long-term bonds in your portfolio. Remember that EE-Bonds require a 20-year commitment to become a worthwhile investment and if you don't have that long an investment horizon you should not be considering them. Of course, you can also make the choice of foregoing long-term fixed income investments altogether until interest rates rise. This is not unreasonable. But, unfortunately, there is no guarantee that the interest rates will rise any time soon. Around the middle of 20th century they stayed at these levels for a couple of decades!

I wish I could tell you whether today's long-term fixed income investments are to be jumped on or avoided, but I cannot. What I can tell you with high degree of certainty is that of what's available in this space, EE-Bonds are the best deal going. If you wish to hold long-term bonds today, and especially if you have to invest in taxable accounts, then you have to very strongly consider EE-Bonds.

Remember that you can buy EE-Bonds only electronically through TreasuryDirect.gov at up to $10,000 per calendar year per Social Security number. It takes just a few minutes to sign up online and make the purchase. And not to put any pressure on you, but you only have a couple days left if you wish to buy your 2012 allotment of EE-Bonds.