Getting a bang from bonds: savings bonds - from zeros to EES - stand to offer great, safe rewards

Black Enterprise, July, 1993 by Carolyn M. Brown

Novice investors are often driven to fixed-income securities - namely bonds - because they're cheaper than stocks and help to counter low inflation. Bonds also offer another level of comfort: With their fixed rates of return, they're likely to grow your money at a steadier rate than, say, stocks or mutual funds.

Unfortunately, many folks play the bond game by trial and error, often ignoring the fact that bond yields are tied to changing interest rates. Thus, the lower the rate, the smaller the return on your investment For instance, last February, the Treasury Department lowered the guaranteed minimum interest rate on savings bonds - one of the best savings deals left. Series EE and HH savings bonds dipped from 6% to 4%.

While the short-term prospects for bonds may not look too bright, there's definitely light at the end of the tunnel. Interest rates will probably lag for another two years. But by 1995, says Vernon J. Brown, certified financial planner and principal of V. Brown & Co. Inc. in White Plains, N.Y., "Interest rates will move upward." Our advice: Avoid locking in your money short-term at today's rates. But if you're thinking long-term or simply can't stand to waft for rates to go up, hedge your bets by investing in bonds with scattered maturities, say from two to 10 years. Perhaps the safest bonds are those that are backed by the government: Treasuries, Zero Coupon bonds and U.S. savings bonds.

Treasury Bonds And Notes

The biggest advantage of Treasuries is government protection. It's unlikely the government will default on its obligation. Or it will seize the opportunity created by failing interest rates to refund your principal prematurely and reborrow the money at a lower cost, as is possible with corporate bonds.

You can buy notes and bonds in minimun denominations of $1,000. However, the maturity on Treasury bonds is a flat 10 years, compared with maturities of up to 10 years for notes. Treasury bonds are sold through brokers but usually for commissions lower than stock purchases (i.e., 1% vs. 3%).

Interest earned is free from state and local taxes, and Treasury bonds pay interest income twice a year. The current rate is 6%. Of course, you risk the loss of your principal if you sell Treasuries before maturity.

Zero Coupon Bonds

If you are looking for a higher rate of return, then consider Zero Coupon Treasury bonds. "At a rate of about 7.5%, the return on Zero Coupon Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities) makes them a competitive alternative to other low-yielding fixed-income investments, especially savings bonds," says Gail Perry-Mason, a financial adviser at Prudential Securities Inc. in Detroit.

Zero Coupon Treasury STRIPS, Mason says, can be timed to meet individual investor's needs, and are particularly smart for conservative retirement savers: Ranging in rates from roughly 6% to 8.5%, they are sold at 100 different maturities for up to 30 years.

Zeros are sold through brokers (typically for about a 1% commission charge) and represent ownership of future interest or principal payments, normally on U.S. Treasury bonds. The government is obligated to pay the interest and principal in full when the bond reaches maturity.

Zero Coupon Treasury STRIPS are sold at a discount or at face value and in denominations as small as $30. For $692, a potential investor could purchase a Zero Coupon Treasury STRIP with a face value of $1,000, yielding 7.5% and maturing in 5 years (see chart for more examples). A clear advantage of adding Zero Coupon Treasury STRIPS to your financial holdings is that you don't have to reinvest the interest, says Pierre Dunagan, account executive at Dean Witter Reynolds in Matteson, III. The interest compounds automatically until the bond reaches final maturity.

What happens if interest rates decline during the life of Zeros? Nothing. The market value and yield of these securities change only if they are sold before maturity. Should you need to sell your Zero Coupon bond prior to maturity, the interest rates at the time will dictate how much you get back. If rates rise, you stand to receive less than you paid for the bond. But if they fall, you stand to get back more than you put out.

A downside of Zeros is that they are not tax-free. Earnings are subject to taxes yearly even though you don't receive a dime.

Savings Bonds

Uncle Sam may have pulled the rug out from under savings bonds in February by lowering rates two full percentage points. Still, in spite of these lower yields, U.S. Savings Bonds are worth looking at. For starters, they are one of the few potential federal tax-break investments left for those saving for college.

Parents can escape any federal income tax on bonds redeemed for college expenses if their gross income - including interest earned on the bonds - doesn't exceed $60,250. The cap is $45,500 for single parents. The tax exemption phases out completely at $98,250 for couples and $60,500 for single parents.

But Congress is looking to do away with income requirements. Should this come to pass, savings bonds will be even more attractive alternatives for financing a college education. Without income limitations, Series EE bonds would be tax-free as long as they are used for college expenses.