Savings bonds are considered a low-risk investment, which could be viable for those looking at more conservative investment options (although all investments involve a degree of risk).
There are usually two varieties of savings bonds - one with fixed rates and another which is inflation-adjusted. Keep in mind that savings bonds are long-term investments.
But what are savings bonds exactly, and how do they work? What do you need to do to invest in savings bonds? Who can invest in savings bonds? We will now take a look at these and other common questions.
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Savings Bonds Explained
Whenever we talk about loans, most people will immediately think about banks and interest rates. Saving bonds work in a similar way: the individual is the one loaning money to the government and in turn, potentially earns a return based on its interest rate.
However, while regular loans come with an obvious risk (the borrower defaulting), that’s not the case for savings bonds. These are widely regarded as one of the safest investment options around.
An individual is loaning money to a national government, which makes the risk lower than other investment options. They are backed by the “full faith and credit” of the respective national government. In other words, one potential risk involved would be the country defaulting on its debts - a possibility that is unlikely but always possible.
It’s also important to keep in mind that the investor would face monetary penalties if they chose to redeem the bond before the maturity date. Another risk to consider is when you choose to redeem your bond(s), it should not be before the interest is posted to review by the given fund – doing so can cause you to lose the accrued interest.
But why do savings bonds exist? This kind of investment was first signed into law in 1935 by U.S. President Franklin Roosevelt. The US Department of Treasuries then started issuing debt securities that were available for anyone to buy.
Initially, savings bonds could only be acquired through paper certificates. Nowadays, they are available almost exclusively online, making the whole process faster and much safer for investors, as the records are stored electronically, rather than paper certificates which could be lost.
Types of Savings Bonds
Savings bonds are usually divided into two different types. One has fixed rates, while the other is inflation-indexed. It’s worth mentioning that some inflation-indexed savings bonds also have fixed rates along with a second rate based on inflation.
Let’s use the U.S. savings bonds, one of the most popular available, as an example to explain this. The U.S. government currently issues two types of savings bonds: Series EE bonds, which have a fixed rate, and Series I bonds, which are adjusted for inflation.
Series EE bonds are guaranteed to double in value 20 years after being issued. Even if that doesn’t happen automatically, the government will make an adjustment to ensure it. Series EE savings bonds will continue to accrue interest for 30 years from their issuance.
Series I bonds, meanwhile, have a combined rate, which is made of two different components. One of them is fixed and therefore will remain the same until the investment is withdrawn. The other is inflation-indexed, which is adjusted every six months. Just like Series EE bonds, Series I bonds accrue interest for 30 years after being issued.
Both Series I bonds and Series EE bonds are available at a minimum investment of $25 and limited to a maximum investment of $10,000 each in a calendar year. There is, however, no limit to how much you can own in total savings bonds.
Inflation-indexed bonds offer additional protection against high inflation rates. However, if deflation happens, then their combined rate may drop below the fixed bonds’ rate.
It’s worth noticing that you won’t be at risk of losing your initial capital if that happens. You will simply earn a smaller return instead.
How to Redeem Saving Bonds
Savings bonds are considered long-term investments. First of all, the money will remain locked for a certain amount of time. Going back to the U.S. savings bonds, the investment remains locked for one year.
Once that time period is over, you are free to withdraw it again. However, cashing in before five years will make your investment lose three months of interest, most generally speaking (but not necessarily for all savings bonds or countries).
Taxes are always a sensitive topic when it comes to investments. Savings bonds do not have to pay taxes on their interest payments. The individual will only pay taxes once they cash in. This rule is applicable in the US however may not apply to all countries.
Since the majority of savings bonds these days are bought online, cashing in is a lot easier and faster. One can redeem it at the respective national treasury department or at the bank using your own account. Most banks offer their clients this option, which speeds up the whole process.
The owner (or their beneficiaries in case of death) is the only one authorized to cash in the savings bonds. Alternatively, it is also possible to name a co-owner.
Always keep in mind that the longer you leave the money untouched, the higher your returns are potentially going to be, in the majority of cases. This can vary dependent on the savings bond or country. Savings bonds continue to accrue interest until the maturity date.
Of course, your funds will remain available for cashing in even after the bonds mature. The investment will simply stop accruing interest.
What Are Savings Bonds? Conclusion
Savings bonds are considered a low-risk investment option compared to others, making them a very popular alternative.
It’s also important to learn about the types of bonds available. Just like in most low-risk investments, remember to take the inflation rate into account.
While there is no risk of losing the initial capital investment with government savings bonds, there is a chance the interest will end up dropping below the current inflation rate. In this case, despite not the capital investment, one would be getting less value out of your investment.
Savings bonds should be considered a long-term investment. They will keep accruing interest over time, so the longer you leave them untouched, the higher the returns may be (depending on market conditions).
Early withdrawals may be penalized with smaller returns and a loss of interest. Prior to that, the investment will also remain locked in for a set period of time, so make sure you won’t need this money even in an emergency.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.