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Why I REALLY Don't Like EE Bonds

The U.S. Treasury offers two types of savings bonds: I bonds and EE bonds. I bonds' yield is tied to inflation, specifically, the CPI-U metric. With the inflation we've seen in the last few years, I bonds have literally "exploded in popularity." I bonds bought at the time of this post will pay .90% annual interest, compounded semi-annually, above CPI-U until they are cashed or mature in 30 years (note that I bonds cannot be cashed until at least one year after they are purchased). They are exempt from state and local taxes, and the interest they pay is tax-deferred until they are cashed. As I've noted before, I like I bonds mainly because they offer guaranteed protection against unexpected inflation, which has historically been the single biggest risk to fixed income investments, though the tax deferment is a nice bonus. Treasury Inflation-Protected Securities (TIPS) of most maturities are currently paying a higher interest rate, but unless they are held in a tax-advantaged account, their after-tax yield may be lower than that of I bonds for some investors.

EE bonds are a very different instrument. They pay a nominal interest rate and are not tied to inflation in any way. For many years, the main feature of EE bonds has been that they double in nominal value 20 years after purchase. If they are held for those 20 years, this works out to an annualized nominal return of 3.53%. But if the EE bonds are redeemed prior to the 20 year period, they return only their stated interest rate, which is currently 2.5%.

I'm not a fan at all of EE bonds and haven't been for a long while. Below, I describe why.

Early Withdrawal 'Penalty'

If EE bonds (or I bonds) are redeemed earlier than five years from their purchase date, you lose the last three months' interest. But there is another 'penalty' of sorts at work. If you redeem EE bonds before their 20th anniversary, you only get their stated annual interest rate of 2.5%, not the 3.53% return you would get by waiting for 20 years.

These days, this situation is much better than it was not long ago. From November of 2015 until November of 2022, the stated interest rate on EE bonds was an abysmally low .1%. At that rate, if an investor held EE bonds for 10 years and then cashed them for whatever reason, they'd only have a total pre-tax return of 1%. Obviously, the doubling of EE bonds' nominal purchase price was the primary reason that any investors were attracted to EE bonds during that period. But even now, investors in EE bonds are effectively penalized a 1% cumulative annualized rate of return by redeeming them prior to their 20th anniversary.

Difficulty in Rebalancing

Due to the above early withdrawal penalty, EE bonds are not very good for portfolio rebalancing purposes. While they can be cashed out any time after the mandatory one year 'lock-up' period, the above referenced penalty grows increasingly large by cashing them before the 20 year doubling occurs. As an extreme example, if investors cashed out $10,000 of EE bonds paying 2.5% one day prior to their 20th anniversary, they'd have $16,386.16. But if they held them for one more day, they'd have $20,000 instead, 22% more.

Again, this situation is substantially better than it was a few years ago when the stated interest rate of EE bonds was .1%. One day prior to their 20th anniversary, $10,000 originally invested in EE bonds would only have been worth $10,201.91, resulting in a much bigger early withdrawal penalty and, consequently, making them much less effective for rebalancing. But still, EE bonds redeemed before the 20th anniversary lose significant interest, resulting in them being less effective for portfolio rebalancing than other bonds.

Inflation Risk

With the stated interest rate on EE bonds at 2.5%, the above issues with EE bonds are not nearly as meaningful as they were earlier. But the single biggest risk with fixed income, namely, the risk of unexpected inflation, is still very much present with EE bonds.

From 1970 to 1990, the U.S. dollar lost 70.5% of its value. This means that $1 in 1970 had the same buying power as $3.40 in 1990. If you only doubled your initial investment in nominal dollars over that period, then your cumulative, inflation-adjusted return would have been -41.1%. In other words, you would have lost a lot of buying power.

I don't believe that we're likely to see such high inflation over the next 20 years. But many investors didn't expect inflation in 2022 to reach nearly 10% either. A lot can change in 20 years, and even if the Federal Reserve's target rate of inflation is 2%, there's obviously no guarantee that they will achieve their goal.

As such, EE bonds are not 'risk-free', as some have touted them to be. They are free of credit risk, but they are very much exposed to inflation risk.

EE bonds guarantee a future, nominal dollar amount, but, in and of itself, that is meaningless. Guarantees of future buying power are of far more value to investors.

It's certainly true that all nominal bonds are exposed to the risk of unexpected inflation. And it's for this reason that I believe inflation-linked bonds (i.e., TIPS and I bonds) to be superior for most investors, as I noted in one of my earliest blog posts. In the lion's share of circumstances, there is no good reason for investors to take on the risk of unexpected inflation in return for virtually nothing. One of the few exceptions to this is investors who don't have access to inflation-linked bonds in a tax-advantaged account in their workplace retirement plan.

Wrangell-St. Elias National Park

Opportunity Cost

Logically, if you invest a dollar in one instrument, you cannot invest that dollar in anything else. Investors who choose to buy EE bonds are foregoing all other potential investments.

So, what other potential investments should we compare EE bonds to? Treasury bonds seem like the obvious choice, and those are yielding 4.42% as of this writing. That's a .89% higher annual yield than the 3.53% that EE bonds will return if held for 20 years and 1.92% higher than EE bonds yield if they are cashed out before that time. Treasuries are marketable, so investors aren't 'locked in' to holding them until maturity, though selling them before they mature will almost certainly result in a different return than their initial yield. The only advantage that EE bonds might have over Treasuries is that they grow on a tax-deferred basis, but this is only an advantage if the Treasuries would be held in a taxable account.

The second most similar investment, I would argue, would be I bonds. These savings bonds are also tax-deferred, but they introduce a new variable: inflation. I bonds are currently yielding an inflation-adjusted .90%. That means that if inflation averages under 2.63% over the next 20 years, investors would have a higher return with EE bonds and vice versa if inflation averaged above that level (i.e., the break-even inflation rate).

However, Treasury Inflation-Protected Securities (TIPS) that mature in 20 years are currently yielding an inflation-adjusted 1.84%. At that rate, the break-even inflation rate is only 1.69% (ignoring taxes).

Both Treasuries and TIPS seem like a slam dunk better alternative for most investors.

Another alternative for funds that an investor is willing to tie-up for 20 years is stocks. Obviously, the return of stocks is far from guaranteed, but to the extent that the future resembles the past, stocks held over a 20 year period are substantially less risky in terms of preserving buying power than EE bonds.

From 1929 to 1948, the U.S. stock market had a nominal return of 3.03% on an annualized basis. That was the worst 20 year period in U.S. stock market history with regard to its nominal return. If the starting year was moved at all, the average return improved significantly. For instance, U.S. stocks returned 4.60% from 1928 to 1947 and also from 1930 to 1949. Note that the 1929-1948 period was the only 20 year period where U.S. stocks had a return under a nominal 3.53%.

And for most investors, the decision to buy EE bonds isn't a 'one-off' event; rather, it's something that they must do over the course of multiple years in order to build up enough EE bonds to be of substantial value. So, even though a 3.53% nominal return would have outperformed U.S. stocks from 1929 to 1948, investors who would have bought EE bonds with such a nominal return in 1928, 1929, and 1930 would still have underperformed U.S. stocks in totality.

Again, stocks' return isn't guaranteed. But the historic opportunity cost of holding an investment with a 3.53% nominal yield for 20 years was tremendous. Whether the Treasury's guarantee of a 3.53% nominal yield is more valuable than the upside potential of stocks is a matter of opinion, but from a historic perspective, it's not even remotely a contest. And stocks are not the only asset class other than bonds that investors could own in lieu of EE bonds; real estate would be another logical choice.

What Assumptions are Needed for EE Bonds to Make Sense?

Given the above conditions, EE bonds only make sense for investors for whom ALL the conditions below hold true.

  1. They are confident that they don't need the funds they would use to buy EE bonds for 20 years and are willing to accept a 2.5% annual nominal return if the funds are needed earlier.

  2. They expect inflation to average 1.69% or less over the next 20 years (i.e., the difference between EE bonds' 3.53% nominal yield and the 1.84% inflation-adjusted yield of 20 year TIPS as of this writing), ignoring taxes.

  3. They expect that a tax-deferred 3.53% nominal return will provide a higher after-tax return than a 4.42% nominal return (i.e., the nominal yield of 20 year Treasury bonds as of this writing) that is not tax-deferred.

  4. They prefer a guaranteed 3.53% nominal return over the uncertain but very likely higher return of stocks, real estate, etc.

The number of investors who meet all those criteria seems likely to be extremely small to me. In particular, expecting inflation to average 1.69%, roughly .3% lower than the Federal Reserve's target inflation rate of 2% and roughly .9% lower than the 2.6% average annual inflation of the last 20 years, seems unwise. The spread between 20 year nominal Treasury bonds and TIPS, widely considered to be a good measure of the bond market's estimation of future inflation, is currently 2.55%.

Final Thoughts

In their current form and at their current yield, it seems that EE bonds make virtually no logical sense for the lion's share of investors. Investors willing to hold 20 year Treasury bonds can earn a significantly higher return, albeit one that isn't tax-deferred, and have the ability to sell their bonds before then without an early withdrawal penalty. Those who don't want to take on the risk of unexpected inflation can buy 20 year TIPS paying 1.84% above inflation. And investors willing to take on uncertainty in their returns may desire to hold U.S. stocks, which have outperformed a 3.53% nominal return in every 20 year period on record save one.

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