First, how they work. EE bonds have a fixed rate of interest. This rate is permanently established on the day that you buy the bond. According to Treasury, this rate is determined by “adjusting the market yields of the 10-year Treasury Note by the value of components unique to savings bonds, including early redemption and tax deferral options.”? I think this means that Tim Geithner makes it up on the spot (although I have been unable to verify this.)
These bonds grow in a tax-deferred fashion (like I-bonds.) You owe taxes when you redeem the bonds or when the bond reaches full maturity (after 30 years.) Once 30 years have elapsed, the bond stops earning any interest and it’s time to pay the tax man. (They're also free of state and local taxation.)
Similar to I-bonds, EE-bonds must be held for one year. If they are redeemed in their first five years, 3 months of interest is charged as a penalty. For example, a bond redeemed after being held for 48 months would net the original principal, plus 45 (48-3) months of interest. After five years, the bonds can be redeemed at any time without penalty.
There is a second way that EE bonds can pay off. If they are held for 20 years, they immediately double in value (assuming that the rate of interest at which they were issued hasn’t made them more than double in value already.) At current rates (0.6%), this is a very important mechanism as it yields an interest rate that’s equivalent to ~3.53%.
Basically, if these bonds match or nearly match the prevailing interest rate, they are a pretty good buy. If they fall significantly below the prevailing interest rate, you always have the option to redeem them if you’ve held them for at least a year. The potential penalty is only three months of interest, which is just not all that scary.
The current rate of 0.6% is roughly equivalent to about a two-year T-bill. Additionally, if we go through a very long stretch of extremely low interest rates, the 20-year doubling is a nice way to achieve a “sudden”? >3.5% interest rate.
So do they fit into the Permanent Portfolio? This is my interpretation of the requirements for a "Cash" instrument in the Permanent Portfolio:
- Must be backed by the full faith and credit of the United States government. Yes.
- Must be highly liquid and available at a moment's notice. Sort of -- they are liquid after one year.
- The principal must be free of interest rate risk and the security must at minimum always retain its full value. Yes.
Anyone else have any further thoughts \ corrections on EE bonds? I'd be curious how you fit them in, if at all.