It’s slightly ahead of actual inflation. An inflation calculator shows that $10,000 in 1997 is worth $15,272 today, so you can be reasonably confident you’ll be ahead of inflation with the government’s guaranteed 3.5% return (plus, the government promises the performance, so is about as risk-free as you can find in the market, although reasonable minds can disagree about the safety of the US government’s ability to repay the bond). At the same time, if you looked at inflation from 1977 to 1997, the $10,000 would have inflated to $26,485, meaning you would have lost money with your guaranteed 3.5% return.
The problem here is that the 3.5% guaranteed return is nominal and not real. Nominal return refers to the actual return you’ll receive (in our case 3.5%). However, your real return takes into effect the purchasing power of each dollar. It would be much better to have a 3.5% guaranteed real return. If you make a deal with a guaranteed nominal return, you run the real risk that your real return could be less than zero if inflation is above 3.5% over the 20-year term of the Series EE Bond.
So, what we know if that investing in a Series EE bond still exposes you to inflation risk.
But getting a 3.5% guaranteed nominal return is still a good deal in today’s market. If you purchased a 20-year Treasury bond (i.e. not a Series EE bond) today, you’d only get a 2.85% nominal return, making the Series EE bond’s return look attractive. Keep in mind that the better nominal return of the Series EE bond comes at a price: reduced liquidity. The Series EE bond only pays 0.10% interest annually unless you hold it for the full 20 years to maturity. If you decide to sell it at any point in time before it doubles, you’ll likely suffer a real loss since inflation will almost certainly exceed 0.10%.
Since holding the Series EE bond for 20 years to maturity is the only reasonable course of action, the Boglehead wiki suggests that a Series EE bond could be used as a tool to help ensure the delay of Social Security benefits. As a general rule, for every year you delay taking Social Security your benefits increase by 8%, thus making it valuable to delay Social Security payments until 70 if possible. If you buy a $10,000 Series EE bond each year starting at the age of 42 through 48, you’ll guarantee yourself $20,000 of income at age 62, 63, etc. If you’re married, you can buy twice as many Series EE bonds each year, so you could buy $20,000 each year from age 42 to 48 and end up with $40,000 of income.
You’re likely to make more money in the stock market and through other investments, but if you believe the US government will be able to honor its commitment, the Series EE bonds look attractive in this scenario where you want a guaranteed nominal return over a 20-year spectrum.
Related: 5 Key Things to Know About Fixed Income ETFs
The other benefit of Series EE bonds is that they are free of state and local taxes at the time of redemption. Further, your federal taxes are deferred until you cash them, which allows you to delay taxes and could result in a tax arbitrage opportunity since you may redeem them at a time with a significantly lower marginal tax rate. The money can be completely tax-free (federal/state/local) if used for specific educational purposes, which offers another incentive.
As for our portfolio, we already have our bond allocation covered by an unusual option in my wife’s retirement account, and I’m still five years away from 42, so the Series EE bonds are not an attractive option for us right now.
If you want to dive more into this topic, I highly suggest reading through the 300+ posts in this Bogleheads thread discussing Series EE bonds. There are good arguments for and against such an investment and no better place on the internet to find an in-depth discussion than the Bogleheads forum!
For more trends in fixed income, visit the Fixed Income Channel.