I am convinced that the Series I savings bond program remains one of the most underrated investments for the average American in history. So much so that I wrote tens of thousands of words on the topic over at my the Investing for Beginners site. But tonight, I was writing a new piece of content to add to the savings bond hub that will be published before morning when it just hit me how truly underrated these are as an alternative to savings for low income and middle class families.
Series I savings bonds are seriously underrated as a savings tool.
Let me give you an example: Right now, the average national rate on a 1-year certificate of deposit at a bank is 0.93%. You must pay Federal and state taxes on that. If you are in the 25% bracket in a tax-free state, your net return is going to be around 0.70%. On the other hand, you can buy a Series I savings bond that can’t be cashed in for at least one year, collect 4.6% interest that is tax-free on both a Federal and State level if you use them for education expenses, and is guaranteed by the Federal government to not lose money. On a tax-adjusted basis, this is the same as a 6.13% yield on a fully taxable certificate of deposit.
What if you don’t use the money for education expenses? You can still defer the taxes owed on Series I savings bonds indefinitely by electing something called “cash basis reporting”. That way, your Federal taxes are deferred until the earlier of the year of final maturity, redemption, or other taxable disposition. That is a huge advantage, effectively providing much of the same deferred taxation benefits of a Traditional IRA. Over time, the cumulative advantage of that tax treatment can be enormous.
Which would you rather have for tying up your money? A certificate of deposit paying a taxable equivalent of 0.70% or a Series I savings bond paying a taxable equivalent of 6.13%? Those are your economic choices at this exact moment.
Series I Savings Bonds Have Their Limits
[mainbodyad]Don’t misunderstand me. I don’t think Series I savings bonds are good investments all the time, or that they should be a part of every investor’s bond portfolio. Actually, they aren’t really investments at all but really savings mechanisms. But for the average person who has a decent job, a good house, a 401(k), a Roth IRA, and just wants to put aside money for the future (at least 12 months or more) and help ensure the money keeps pace with inflation so it is there whenever it is needed (e.g., paying for college, putting a down payment on a house, tapping into for emergencies, etc.), I just don’t think Series I savings bonds can be beat.
One of the things I find most compelling about the Series I savings bond is that it effectively gives you the benefit of up to 30 years compounding without any bond duration. That means if rates increase drastically, you still won’t see a capital loss, whereas with an ordinary 30-year municipal bond or corporate bond, you could see a 50% or more paper loss that would take years to regain.
An Overview of How Series I Savings Bonds Work
- Right now, the Series I savings bond offers an interest rate of 4.60%. This is calculated because these bonds pay an interest rate based upon two components:
- The “earnings” rate: This is set to 0.00% for the life of the bond since rates are so low
- The “inflation adjustment” rate: This increases or decreases with fluctuations in the consumer price index for all Urban Consumers (CPI-U). Right now, this is 4.60% but it will change as the price index fluctuates.
- You can sell your bonds any time you want after 12 months without any loss. Your penalty is limited to 3-months of interest income and it is only owed if you cash in your savings bonds within the first 5 years
- You don’t have to pay Federal or state income taxes on your interest income in some cases if you use them for qualified educational expenses
- You can elect for cash basis reporting of the interest income on your savings bonds, effectively deferring your tax bill for up to 30 years so you have more money compounding for you
- Interest compounds semi-annually for 30 years
- Series I savings bonds are bought at face value
- Can be held in paper form or electronically through Treasury Direct
- You can invest up to $5,000 per Social Security Number per year
Take someone in the 25% personal tax bracket. The current yield on the Series I savings bond of 4.6% is the equivalent of getting 6.13% on a taxable 1-year certificate of deposit! The national average right now is only 0.92%, or 0.69% net of taxes. That means you are getting 888.4% more interest income on your savings bonds than you are with a certificate of deposit! Why would any rational person buy a certificate of deposit when the opportunity cost is so high? It doesn’t make any sense.
The biggest challenge for high income earners is the $5,000 limit per Social Security number, but that can be somewhat managed. If you are a family of five, two adults and three young children, you could save $5,000 per person, per year, or $25,000 in total each year. Over a few years, you’d be able to reach into the six-figures.
[mainbodyad]
Reader Comments (5)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
FratMan
June 14, 2011
Hey Joshua, whenever I read about the stocks of fast food companies, I generally get a similar vibe to that of airline companies--they're great services to use, but stay the hell away from them as investments. But it seems that McDonalds is the lone exception--most financial analysts regard it as one of the bluest of the blue chips, and many sources, including the WSJ, have touted it as a stock worthy of long, long term investment. Which obviously begs the question--what is it that McDonalds is doing so much better than the other companies? Their prices are comparable, if slightly cheaper (but not markedly so) than Wendy's, Burger, et al., and I'm pretty sure the quality of the food offerings is pretty similar...So what is it that McDonalds has consistently done to earn this faith, and have people think it will continue to do so going forward--why do most investors give it the gold standard treatment, do you think?
Joshua Kennon
June 17, 2011
Replying to FratMan
Oh young grasshopper. When I was your age (yes, I really just said that), McDonald's had fallen to a multi-year low and the newspapers were filled with stories about how it would have to turn around or fail. Profits had fallen, service was terrible, hundreds of millions of dollars in shareholders capital had been wasted on horrible ideas, and three (3) CEOs all died on the job within a matter of months (or a couple of years). It was a mess.
But it is true that throughout most of its history, an investor who continually bought shares of McDonald's, reinvested the dividends, and did it year in and year out would have gotten incredibly rich. Likewise, good franchisee owners who ran their businesses well also had a chance to get very rich. If you want to understand the business side of franchising, read the annual report and filings of Arcos Dorados Holdings (symbol ARCO), the biggest McDonald's franchise in the world, which is publicly traded.
I think part of the answer is sheer size. McDonald's operates 32,478 restaurants in 117 countries. Wendy's, in contrast,operates 6,576 restaurants, Arby's 3,649 restaurants, etc. But even that explanation isn't satisfactory because Chipotle operates only 1,084 restaurants and it's performance has been incredible.
A big part of the equation is that restaurants have what is known as high "operating leverage". That means that the fixed expenses are considerable and once you cross those expenses, most of the sales fall to the bottom line as profit. This means that if sales decline below the fixed expense threshold, profits can collapse rapidly. Likewise, if sales increase about that threshold in a turnaround, profits can explode for huge gains. At Wendy's sales declined 2.7 percent last year and commodity input prices are rising, squeezing profits.
So, I think it is:
* Partly culture. McDonald's is a machine.
* Most of the earnings are from franchisees, which requires very little capital, so the "owner earnings" for every dollar of reported net profit are higher than comparable firms that would have to reinvest shareholder capital into bricks and mortar locations. That means more money for dividends, share repurchases, etc.
* McDonald's is really a real estate company. They have figured out how to put restaurants in the best possible areas based on traffic patterns. They almost always have better locations.
* McDonald's advertises more than almost any other fast food company, which has to do with the higher owner earnings and excess cash. Advertising works.
* The sheer scale of the enterprise makes it possible to ruthlessly cut costs, both in terms of raw commodities and distribution
Just for kicks: The average McDonald's is expected to have sales of $2.2 million per year and are widely believed to have average profit margins of 6% to 8%. That would equal $132,000 to $176,000.
There is no doubt that if I wanted to manage businesses for a living as a hands-on operator, I would probably look at the McDonald's system as the most likely vehicle through which I'd build a chain of restaurants. I think someone with talent could make a ton of money over a 30 to 50 year career. There are McDonald's franchises worth hundreds of millions of dollars (nine-figures). The company is filled with stories like this one about Isaac Green.
Plus, the 401(k) benefits are generous; the company literature states:"(Our Profit Sharing and Savings Plan lets employees save from 1% to 50% of their pay on a tax-deferred basis in the 401(k) feature of the plan. McDonald's matches eligible employees' contributions with $3 for each $1 of the first 1% of pay they contribute, and $1 for each $1 on the next 4% they contribute. Eligible employees may also receive a discretionary profit sharing match of 0% to 4% based on the first 1% of pay they contribute. Employees are always 100% vested in their contributions and the company matches.)"
James
June 14, 2011
I'll take a swing at that FratMan....my two cents:
1. Innovation - McDonald's always seems to come up with something new that works; whether it be the new McCafe or changing the entire food preparation system to make it more efficient.
2. Culture - I don't know about other areas of the country but the McDonald's around here have employees that are always hustling. It's like a race to get you your food as fast as possible. But the BKs and Wendy's around here are pretty slow and the employees seem to actually be trying to serve as few people as possible.
Charlene
June 17, 2011
Where do I find a Series 1 savings bond? Do all banks have them? Or do I find them elsewhere?
Joshua Kennon
July 27, 2011
Replying to Charlene
You can purchase them from directly from the United States Treasury at http://www.treasurydirect.gov/