Series I Savings Bonds vs the stock market
Wednesday, April 2nd, 2008
Categorized as: Series I US Savings Bonds • Savings Bonds and competitive investments
Ask 100 financial advisors whether stocks or Savings Bonds are the better investment for the long term, and all the ones who earn commissions selling stocks will tell you that stocks are always the better investment.
Let's take a look and see if they're right. The following figure shows the results of investing an equal amount each month in both Series I Savings Bonds and the Vanguard 500 Index fund.
The graph begins when Series I Savings Bonds were introduced in September 1998 and has been updated through April 1, 2008.
The thin, black line shows how much money has been invested. It goes up very steadily because an equal amount of money is added each month. This month, it's at 116. In other words, the total amount invested is whatever equal monthly investment you choose times 116.
The upper blue line is the total value of the Series I Savings Bond investment. Note that this line always goes up. This month it's 150.45 times the monthly investment.
The red line that goes both up and down is the total value of the stock market investment, including reinvested dividends. This month it's at 142.76 times the monthly investment, up from last month's 137.98. Because of the ongoing financial crisis and recession, the I bond investment is once again ahead of the stock market investment.
And if you had been forced to cash in the stock investment between 2001 and 2003, you wouldn't even have gotten back what you put in.
However, no matter what this graph says, don't buy Savings Bonds expecting to outperform stocks.
Buy Savings Bonds because you can't get back less than you put in. They make a great foundational choice for the low-risk portion of your investment portfolio.
That said, it's clear that people who tell you that a stock investment always outperforms an investment in Savings Bonds don't know what they're talking about.
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Stocks vs. bond returns will always depend on the time frame you select to look at. Personally, I prefer bonds even knowing that if I would have chosen stocks over bonds 20+ years ago, I would be much better off today. After watching several friends pick stocks over bonds in the past few years and promptly lose 20- 30% I like bonds even better.
The story that goes around my family circle - bonds vs. stocks vs. gold is about my great grand parents and the great depression. They immigrated from Switzerland in the early 1900's and were basically poor Oklahoma dirt farmers even with several hundred acres of land. They were considered well off thru 1930's because they owned at least some bonds and no stocks. They did however surrender their gold when Roosevelt made it illegal for the public in 1932 and then doubled the price once the public had "rendered unto Caesar".
In a country that constantly harps about the low to negative savings rate of Americans, I do find it ridiculous that bond interest which for the most part is nothing more than inflation rendering a zero return after taxes, is taxed as ordinary income and can be as high as 35% while stocks enjoy a maximum 15% long term capital gain if held for only one year. Of course stocks have never been touted as "Patriotic" the way bonds have either :')
As for CD's vs. Bonds, one of my prized possessions is a cancelled check from Union Trust Bank Oklahoma dated Nov. 1934 payable for .06 cents. It has a signature on the back and written under it "In memory of $100 withdrawn on time".
Completely agree with Charles' comment on bond taxation - even more ridiculous that bond funds' distributions are also taxed at ordinary income vs. stock dividends at reduced capital gains. Obviously, the government is trying to make us all go broke during the next recession.
Any advice what a good bond vs. stock proportion of a portfolio might be for a long term horizon? Mine is 95% bonds/5% stock right now and I'm wondering if I'm missing out on some great returns. At least, I'm not losing money.
Mario - until someone has a working crystal ball or is otherwise able to reliably predict the future, you aren't going to get an answer that you can depend on to your question of the best stock/bond mix for your portfolio.
But, given that it's all just guesswork, the thing to watch with stocks is P/E ratios. Long terms moves in the stock market are basically investors falling in love with stocks, which raises P/E ratios, followed by investors being disappointed by stocks, which lowers P/E ratios. We're currently in a long-term cycle of declining P/E ratios, but by historical standards they still have a long way to go.
If you'd be interested in at in-depth look at long-term cycles in P/E ratios and where we are historically, I recommend Unexpected Returns by Ed Easterling.
The I-bond to stock comparison is interesting, but the really useful comparison in my mind would be a comparison of I-bond, EE-bond, taxable money market and/or municipal money market.
Mike - I can tell you in words what the results would show: the I bond line would be where it is in the graph on this page. Under it would be the EE line, under that the money market line, under that the municipal money market line, and then the amount invested line as shown above.
The lines would be on top of one another initially, then they would gradually separate as time went on. Unlike the 500-Index fund line, all of them would be smooth lines with no ups-and-downs.
When I was a dumb kid during the late 1980s through the late 1990s, I had all my investment funds, what I had of them, in corporate bond funds. Stocks were too risky for me. I now kick myself seeing all the gain I could have had if I put my money in even a mediocre large cap blend equity fund. The bond fund drifted up and down as interest rates fell and rose, whereas the S&P 500 went VOOM.
Fortunately, I eventually realized my foolishness and drifted into equities. Granted the dot-com bust in 2000-2002 hurt, especially my dabbling in individual "Blue Chip" stocks, but I took it as a buying opportunity in VFINX and MUHLX. I'm doing much better now, but still regret being all in bonds when stocks were the place to be.
Another reason equities will do better than bonds in the long term is that, as Ron Muhlenkamp says, a company's CFO works FOR the stockholder and works AGAINST the bondholder. How many CEOs own stock options? (a lot) How many CEOs own bond options? (none)
Of course, the chart was based on the original I Bonds, earning ~3.6% + inflation — very generous of the taxpayer, if you ask me. I wonder what the chart would look like if starting from 2003 when I Bonds earned ~1% + inflation? Considering long term Treasuries return about 3% over the rate of inflation on average, I doubt we'll see >3% base rate on the I Bond unless we get another situation of "irrational exuberance" and the Federal Reserve hiking interest rates to draw money out of the stock market.
I bet after today, the I bonds may have the lead again. I really appreciate the I-bond feature of not losing principal especially in these times. If only the base rate was a little higher.
Tom , I have chosen to make I-Bonds an essential part of saving for my daughters education. I am in the 33% tax bracket which boosts the tax adjusted yield of of I-bonds nearly 1.5% yearly. Giving me tax deferred gains of nearly 6 percent for the current issue of I-bonds. There is no other government insured security or investment vehicle that can do that. 529 plans, although tax deferred, cannot promise a greater gauranteed yield with government insured products. I would think that a portion of educational funding invested in I-bonds would make a reasonable cushion against the stock market for anyone.
Okay, I-Bond Rate, 4.52%. eTrade FDIC saving account APY, 5.05%. Even with the small tax savings on I-Bonds, you'll earn more money with eTrade.
So, how is I-Bond better again?
Jud - while on any given day there will be a bank offering unusally high teaser rates to get customers, historically, Savings Bonds have been the better investment.
Tom Adams
Hi Tom, I like to check out this comparison chart each month, but I doubt if one held the Vanguard 500 in a taxable account that the chart would look the same on an absolute return basis. Or, do you account for the tax-deferred compounding of I-bonds? Thanks. -Mike.
Hi Mike - you are correct - on a tax-deferred basis the I bonds would look even better. The chart doesn't take the fact that the Vanguard 500 dividends are taxable each year into account.
Or another way to think of it would be that the chart compares Series I Savings Bonds to the Vanguard 500 Index Fund held in a retirement account.
It wouldn't really be a fair comparison otherwise because you do have to pay tax on the Savings Bonds some day and at that point the after-tax redemption value of the I bonds would drop, but that drop would never appear on the chart.
Tom Adams
As I look back and wondered what made me buy I bonds, I remember a bank employee telling me they are better than CD'S. Well he was right. Two things bother me so. First, as stated before, these bonds are for inflationary benefit, unlike its counterpart, the EE bond. Why buy bonds? What is wrong with a 4-1/2% CD.? I feel that the I bond has a lot of better value. The interest is only taxable when you take it out and that may be a long time away. Lets say you earn only $10,000 a year and the tax cut off for paying taxes is the same. You dont pay any taxes. Next year the same thing BUT, the government raise the tax cut off each year, not a lot but a little. Now this year, it may be $10,100. That may pay for the interest you earned. Also, the savings bonds, unlike CD's are free from tax on the state level, which adds a little to the interest rate. They are also free from taxes if you use them for higher education. If So my opion is that bonds are better than CD's.you invest $5000 in a CD and you need the money, you can lose 3 months interest on the whole CD, but with bonds, after one year, you can cash in only what you need, so don't buy 1 $5000 bond. Buy 10 $500's or 100 $50's or some combination like that. I buy bonds and cash them in every five years and buy new ones. I cash them in because I have no taxable income so I take care of the interest then. I am blind and with the exempion I can earn up to $12000 a year before I pay taxes. I cash in say $100,000 and the interest may be $12000. Guess what. No taxes. I then reinvest the money into Bonds up to the $60000 level (paper and electronic) and the remaining the following year. You may be able to do this for children. If you buy bonds in there name at age 10, you cash them in at age 15. If it is there social security number on it they pay taxes. I always recommend seeing a tax perparer first. OK second, why are bonds JUST keeping up with inflation? Good question. I don't know the answer but if you look for the same kind of safety and security that some like myself want, it sure beats banks and other investments like CD's. The I bond is the way to go. The EE bond is so behind the times it is rediculous. The only one that makes money on that one is the government. Stick to I bonds.
could someone help me I am trying to set up a savings for my daughter and I am not sure weather to set up a savings account or go with I bonds?
Hi Tom, With the S&P 500 index dropping nearly 10% for the first 4 weeks of the year, it seems that it had a relatively short, unimpressive reign of out-performance. It's no wonder the government significantly dropped the annual purchase limits of savings bonds. And to think, the government is significantly raising the mortgage limits backed by Freddie, and Fannie? Thanks. -Mike M.
Hi Mike - Buying stocks when the S&P line is below the total investment line on this graph and selling them when it's above the I bond line does look like a profitable way to trade, doesn't it?
It's probably too long-term for most, however.
Tom Adams
Tom, Yes, that would be a great strategy if only one could overcome the desire to buy the safe I-bonds during downturns. Maybe one should start cashing in I-bonds (with the lowest fixed rates first- the May '03's are turning 5 this year) and buying into the S & P index with the proceeds? When I was 30 (and had a relatively long-term outlook) I did not think about such things. But now I don't have as long-of-term of an outlook. I forget which economist (perhaps Keynes or Galbraith) said something to the effect that "we make decisions for the short term because in the long term we are all dead".
And with my oldest starting college this fall, maybe I will cash in some of those older EE's too. Thanks, Mike.
Hi Mike - To be clear, I'm not recommending getting out of Savings Bonds now.
I think it will be six months to three years before stocks find a bottom. This is going to be a long, miserable recession/depression and Savings Bonds are a great place to have your money.
Don't start thinking about switching to stocks until the stock line is the lowest line on this chart.
Tom Adams
Tom:
Looking to retire jul 09. Fully in dropping equities.
Bad/good time to lick my wounds and get out or stay the course for the rise from the bottom?
jim
Hi Jim - My advice has always been to have a portion of your portfolio in low-risk securities. My opinion is that you should move at least 10% into a TIPS fund or something similar.
Tom Adams
the 1999 i bonds probably have higher fixed rate,then more recent i bonds so all i bonds are not beating the market.
Greg - True, but no I bonds are declining in value, either.
Tom Adams
Tom:
Do you think the fixed rate will go higher or lower on I bonds after the MAY 1st ajustment??
jeff
Jeff - unless the level of TIPS interest rates unexpectedly skyrockets between now and May 1, the I bond fixed rate will be lower after May 1
Tom Adams
Who makes the decision to lower the amount of money one can make to I-Bonds.
Robert - I bonds reflect the prevailing level of interest rates in the market. Some would say the Federal Reserve sets those rates and some would say the market sets those rates based on the supply of money available for investment and the demand for loans.
Tom Adams