Unload Old Savings Bonds to Maximize Your Return

If you are among the millions of Americans holding old, relatively high-yielding Savings Bonds, now may be the time to sell.

Interest rate guarantees on nearly $5 billion of 7.5% bonds issued in a bond-buying frenzy 10 years ago are expiring--and those who continue to hang on to these securities will find their returns slowly ebbing. And many bond holders may not be aware of the risk.

“My impression is that most Savings Bond owners think that the rate they bought at is the rate it stays,” says Daniel Pederson, president of the Savings Bond Informer, a Detroit-based company that sells detailed Savings Bond reports to bond owners.

In fact, the so-called guaranteed rate on a Savings Bond is good only until the bond hits its original maturity date. For the billions in bonds sold between March 1983 and October 1986--a point when guaranteed interest rates were at 7.5% per annum--that original maturity date was 10 years from the date of purchase.

(There was a big rush to buy 7.5% bonds at the end of October 1986, after the Treasury announced it would drop the guaranteed rate to 6% the following month. Roughly $5 billion in bonds were sold exactly 10 years ago next month--roughly twice the normal volume of Savings Bond sales. And $19.9 billion were sold in the first nine months of 1986. Roughly $14.5 billion of those bonds remain outstanding.)

After the initial maturity date passes, bonds that aren’t redeemed accrue interest at a lower rate. Unfortunately, there’s no easy way to calculate what that interest rate is going to be. That’s because no one actually pays interest on the bonds until you cash them in. At that point, Treasury officials calculate your return by determining which is higher: a blend of all the guaranteed rates during the time you owned the bond, or the so-called market interest rate, which amounts to 85% of the going Treasury rate during that same period. It’s an either/or proposition. You don’t get the guaranteed rate for a set period and then switch to a market rate, as some people assume, Pederson adds.

For people who bought during the bulk of the 7.5% years, the new “guaranteed rate” is set at 4%. The market rate is adjusted every six months to match 85% of the average Treasury note rate during the preceding six-month period. The blended market rate for bonds purchased in October 1986 is 6.2% today, says Pederson.

So people whose guaranteed rate lapses next month will find their bonds accruing interest at the new guaranteed rate--4%--for at least the next several years. If interest rates stay at today’s levels, investors who keep their bonds will lose the benefit of having that 7.5% guarantee within a few years, Pederson adds. That’s simply because the blended market rate is likely to produce a higher redemption value at the end of the term than the rate obtained when you blend the 7.5% guaranteed rate with the current 4% guaranteed rate on these bonds.

Consequently, savvy investors would be wise to analyze the question: Are you better off keeping the bonds and accepting the lower interest rate going forward? Or should you cash them in next month and reinvest the proceeds in a higher-yielding investment?

Clearly, finding higher-yielding investments isn’t difficult. But the “better-off” question is complicated by the issue of federal income taxes.

In most cases, people who buy Savings Bonds opt to defer federal income tax on the bond interest accruals until the interest is paid when they cash in the bonds, says Pete Hollenbach, a spokesman for the Treasury’s Savings Bond division. As a result, those who redeem the bonds will have comparatively less money to reinvest because some of the proceeds will have to be paid in federal tax. (Savings Bonds are exempt from state and local taxes.)

Nevertheless, most bond owners will find they’d be better off by selling because of the remarkably low guaranteed rate they’d earn over the next few years.

Consider a hypothetical consumer, John, who paid $10,000 for a $20,000 bond in October 1986. (Savings Bonds are purchased for less than their face value. They reach face value at maturity.) If John cashes it in, he’d have to pay tax on the $10,000 gain at his ordinary income tax rate, which is 28%. That leaves him with just $17,200 to reinvest. (That’s $20,000 minus the $2,800 federal tax obligation.)

If John keeps his bond--his $20,000--he gets to defer the federal tax bite as long as he holds it--earning 4% per annum, or roughly $800 per year.

What kind of return would he have to earn on the $17,200 to meet or beat the 4% return on the $20,000 bond? Just 4.65%. What if John was in the 39.5% federal tax bracket? He’d have to invest the bond proceeds at 4.98% to end up even.

He could easily get that return by investing in high-grade, double-tax-free municipal bonds, says Mary Beth Sipprell, municipal bond strategist at Payden & Rygel, a Los Angeles money management firm. Muni yields vary based on the bond’s maturity, investment quality rating and state, she adds. However, the going market for 10-year bonds is in the 5% to 5.25% range.

Better yet, whereas the interest earned on Savings Bonds will eventually be subject to federal tax, the interest earned on many municipal bonds is exempt forever from both federal and state taxes.

The bottom line is that if you can earn the same amount on a municipal as you earn on a Treasury, you’re better off with the muni bond. If you can earn more on a muni than you’d earn on the Savings Bond, you’re losing after-tax money every day you hold the Savings Bond instead.

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Are Savings Bonds Worth Buying?

U.S. Savings Bonds aren’t particularly good investments, given today’s interest rates and the fact that the bonds no longer provide interest guarantees.

Those who hold their bonds for five years or more get 85% of the average rate on five-year Treasury notes--that’s 5.53% today. Those who hold their bonds for shorter periods will get 85% of the average six-month T-bill rate, currently 4.56%.

If you can invest $1,000 or more, it isn’t hard to get 100% of those rates by investing in notes and bills directly or through a broker. And six-month and one-year bank rates are often higher.

Meanwhile, those in high tax brackets can get a better after-tax yield on municipal bonds, which are very safe and free of both state and federal taxes. Bond funds often have low minimums. In the long run, stocks and bonds tend to do better still. Many mutual funds will also allow investors to buy shares in small increments--as little as $25 per month--just like Savings Bonds.

Still, if you you want an inexpensive but official-looking and savings-inducing gift for the grandkids, the bonds may be a good choice.