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Treasury Savings Bonds Can Yield More Than Junk

(Bloomberg Opinion) — It seems like a life hack for fixed-income investing.

It’s no secret that investors are living in a lower-for-longer interest rate world. In the U.S., this is clear by any number of metrics. The Federal Reserve’s key short-term lending rate is pinned in a range of 0% to 0.25% and isn’t expected to budge for years, at least; the yield on benchmark 10-year Treasury notes is 0.69%, after never falling below 1.32% before 2020; and the Freddie Mac 30-year mortgage rate set a new five-decade low of 2.86% last week. Meanwhile, companies can borrow as cheaply as ever. One often-cited example is Ball Corp., a junk-rated aluminum-packager, which sold $1.3 billion of 10-year debt last month at 2.875%, the lowest ever for U.S. speculative-grade debt with a maturity of longer than five years.

Now what if I told you there were U.S. Treasury-guaranteed bonds that effectively yield 3.5% over 20 years?

It sounds impossible. After all, Treasury Secretary Steven Mnuchin made a big deal earlier this year about bringing back auctions of 20-year Treasury bonds, like Tuesday’s $22 billion sale, which priced to yield 1.213%. The 30-year U.S. yield peaked at 3.46% during the Fed’s last tightening cycle and is now just 1.44%. So how can a 3.5% return still exist?

In reality, the federal government offers other ways to lend to Uncle Sam besides just the $20.2 trillion of marketable U.S. Treasury securities quoted on a daily basis. One such example: Series EE savings bonds.

I admit, I never would have given these non-tradable bonds a second look if it weren’t for a recent article from David Enna, who writes the Tipswatch blog and has been a longtime investor in Treasury Inflation Protected Securities, with the headline “Seeking Yield and Safety? The Best Choice Is U.S. Savings Bonds.” In it, he made the case that even though EE bonds were something of a “financial relic,” given the current level of absolute interest rates, they’re nothing short of a “nominal superstar.”

At first glance, the savings bonds appear underwhelming, with an annual interest rate of 0.1%. But here’s the key passage, located deep within the question-and-answer section about rates and terms: 

Does Treasury also guarantee the growth in value of an electronic EE Bond?

Yes. Electronic bonds are sold at face value (not half of face value). They start to earn interest right away on the full face value. Treasury guarantees that for an electronic EE Bond with a June 2003 or later issue date, after 20 years, the redemption (cash-in) value will be at least twice the purchase price of the bond.  If the redemption (cash-in) value is not at least twice the purchase price of the electronic bond as a result of applying the fixed rate of interest for those 20 years, Treasury will make a one-time adjustment at the 20-year anniversary of the bond’s issue date to make up the difference.

EE Bonds continue to earn interest until they reach 30 years or you cash them, whichever comes first.

Yes, you read that correctly. The Treasury will double the face value of an EE savings bond after 20 years. Applying the so-called Rule of 72, an equation that states the amount of time for an investment to double equals 72 divided by the compounded rate of return, and fixing the time at 20 years, puts the effective yield at just more than 3.5%. At the 1.2% rate on marketable 20-year Treasuries, it would take 60 years for an investment to double.

Naturally, this elevated rate of return comes with some caveats. Most obviously, the money has to remain locked up earning 0.1% interest for 20 years before it suddenly doubles, at which point the buyer must remember to instantly cash in the bonds. Redeeming them early comes with a small penalty and an even more meager return. This also isn’t for giant pension funds or other institutional investors — Treasury has a $10,000 cap per person per year on purchases of EE bonds. It’s a strategy, in other words, that requires a lot of patience and diligence but can’t be scaled up.

The bonds’ other advantage, on top of the huge bump in value after two decades, is that they “are exempt from taxation by any State or political subdivision of a State, except for estate or inheritance taxes,” according to the Treasury. That’s a big perk for the millions of Americans living in high-tax states like California, Connecticut, New Jersey and New York.

In an earlier era, given the current level of interest rates relative to the EE bond program, buying the savings bonds would be a no-brainer piece of financial advice for retail investors. Nowadays, with the prevalence of no-fee stock trading and evidence that individuals are opting for “lottery ticket” wagers in the options markets, it’s anyone’s guess whether a strategy that takes 20 years to return 3.5% is enticing enough to catch on in any meaningful way. Why bother with that when the online crowd says “stocks only go up” and the Fed seems all too happy to encourage risk taking, not to mention allowing inflation to overshoot its 2% target? 

I’d think about it this way. Young people are probably better off parking the money they can afford to invest in riskier securities, which over two decades should deliver returns better than 3.5%. Older investors may not want to wait 20 years for the face value to double. That leaves a small subset of Americans in their 40s and 50s, who already are well on their way to creating nest eggs and who are looking for a safe fixed-income alternative on the side, as the target demographic.

For those people, socking away $10,000 a year starting at age 40, which is guaranteed to turn into $20,000 a year starting at age 60 and is exempt from state and local taxes, isn’t a bad plan by any stretch. Savings accounts and certificates of deposit are likely to yield next to nothing for the foreseeable future, while interest rates on investment-grade corporate debt and even junk bonds seem headed ever lower, too. Until Fed Chair Jerome Powell starts “thinking about thinking about” raising interest rates or scales back the central bank’s bond-buying program, the real inflation-adjusted yields on Treasuries should remain deeply negative.

The phenomenon of negative real yields in the U.S. has led some money managers to conclude that stocks, junk bonds and other risky assets are their only choice, simply because there is no alternative (TINA) in fixed income. That may be true at an institutional level. But for individual investors, at least for the next few years, buying U.S. savings bonds will remain a sort of niche arbitrage opportunity worth considering. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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