Uncle Sam's Bonds:Slow,Steady,Safe

Question of the week:I'd like to diversify my investments (which are now mostly stocks) and am considering savings bonds. Do you think they're hopelessly old-fashioned, or could they actually be useful in my portfolio? --Barb M.

Dear Barb,

Given the roller coast ride the stock market has taken us on lately, I can certainly understand your inclination to duck into something a bit more sure. And you have plenty of company--according to the U.S. Treasury, over 55 million Americans own savings bonds.

When we asked members of the Armchair Millionaire community about why they like savings bonds, we heard a number of responses. This one is typical:

Love those bonds. "I bought some Series I savings bonds a couple of years ago. The things I like about them are safety (no chance of losing principal when interest rates rise, as with a bond fund), no commissions, hedged against inflation, and a decent rate of return (versus cash and bonds, anyway). They won't match stocks for the long run, but seem to be a good place for 'rainy day' cash and as a diversifier." --Jack

As Jack points out, savings bonds offer some very nice features that can really help round out a portfolio. And while I believe that most people investing for the long term should be primarily in stocks (or stock funds), I do think that fixed-income investments (such as bonds) can also have a place in a common sense portfolio, as well. And savings bonds are definitely the easiest bonds to buy. If you decide that savings bonds are right for you, my guide will give you what you need to get started.

The Armchair Millionaire Guide to Savings Bonds

• The basics. When you buy a savings bond, you're making a loan to the government, which promises to pay interest in return. Savings bonds are backed up by the full faith and credit of the United States, making them perhaps the safest investment around.
• Your choices. While there are currently three kinds of bonds available, I recommend only the Series EE and I bonds because they are easy to buy, provide tax advantages and offer nice interest rates.
  • Series EE bonds. These bonds are issued at one-half of their face value (so a $50 bond costs $25), in denominations ranging from $50 to $10,000. The interest rate on EE bonds is adjusted every six months and is currently set at 2.66 percent. This interest accumulates until you redeem the bond, or for up to 30 years.
  • I bonds. These are a lot like EE bonds, except that their interest rate is intended to keep your investment growing ahead of inflation. At the moment, I bonds are paying 4.66 percent interest. Also, I bonds are purchased at full face value (so a $50 bond really does cost $50), in denominations of $50 to $10,000.
• Buying 'em. There are three easy ways to buy Series EE and I bonds:
  • From almost any bank, credit union or savings and loan.
  • Directly from the U.S. Treasury through its EasySaver program at www.easysaver.gov. EasySaver lets you buy savings bonds online and make regular purchases (like monthly) with automatic withdrawals from your bank account.
  • If your employer offers it, through your payroll savings plan.
  Regardless of how you buy your savings bonds, there's never a fee or commission.
• Cashing 'em in. Savings bonds easy to redeem. The only requirement is that you have owned the bond for at least 12 months. (Although if you redeem one before you've owned it for five years, you'll pay a penalty of three month's worth of interest.) Just about any full service bank can redeem them for you.
• The tax advantage. Federal income tax on the interest you earn is deferred until you cash in your bond, or until it stops earning interest. And depending on your income and other circumstances, you may not have to pay federal tax on the bond's interest if it's used to pay for higher education expenses. In addition, the interest on savings bonds is exempt from state and local income taxes.

THE BOTTOM LINE: If you're considering bonds for your portfolio, the convenience and simplicity of savings bonds make them an obvious first choice to get your feet wet.

Balancing With Bonds

Question of the week:With the stock market so volatile lately, I'm considering bonds. I've never invested in them before, so can you give me some guidance to get started? --GT

Dear GT,

As you know, two of the basic investment choices are stocks and bonds. Stocks offer you the best long-term growth potential, while bonds give your portfolio some stability. It's the classic tradeoff between risk and return, and the trick is determining what proportion of each is right for your situation.

In general, I believe that most investors who have time horizons of at least five to ten years can afford to be completely in stocks--unless they just can't stomach the volatility that an all-stock portfolio has these days. In that case, a small percentage of bonds will help a good bit in smoothing out those swings.

Here's how one member of the Armchair Millionaire community uses bonds for balance:

"I've always had a couple of balanced mutual funds that were each about 30 percent bonds, so my overall portfolio has been 10-15 percent bonds for the last five years or so. It helped a lot over the last three years. I have friends who have lost three-fourths of their portfolios because they were entirely in aggressive growth mutual funds. I haven't experienced anything like that kind of loss." --IMF

If you decide that bonds are right for you, my guide will give you a quick introduction to the subject.

The Armchair Millionaire Guide to Bonds

• The basics. When you buy a bond, you receive periodic interest payments over the life of the bond. When it matures (maturities range all the way from one day to 30 years), you'll receive the face value of the bond back. The actual return on your investment is called the yield.

• Types. Bonds fall into three major categories:
  • Treasury bonds (and bills and notes), are issued by the U.S. government and backed up by its full faith and credit--you never have to worry about the U.S. not paying you back if you buy some of its bonds.
  • Municipal bonds are issued by state and local governments and are attractive because their interest is exempt from federal and sometimes state and local income tax.
  • Corporate bonds are issued by companies. These bonds usually offer higher yields than other types because there is generally more risk involved--companies are more likely to run into financial problems than the federal or local governments.

• Risks. Bonds are not necessarily the "safe" investment that many people assume. They do carry risks, some kinds much more than others. Here are some of the risks inherent in bond investing:
  • Inflation risk. Inflation can erode a bond's value over time. Bonds with the longest maturities are the most subject to inflation risk.
  • Interest rate risk. When interest rates go up or down, the prices of bonds are directly affected.
  • Market risk. Bonds follow the laws of supply and demand just like any other investment, and their prices can rise and fall accordingly.
  • Credit risk. Aside from U.S. Treasury bonds, there is always a risk that the issuer of a bond may fail to repay its debt. Two well-known companies--Standard & Poor's and Moody's--rate the credit of most bond issuers, so you can have a clear idea in advance of their creditworthiness.

• Where to buy. You can buy government bonds directly from the U.S. Treasury, or you can buy bonds of all kinds through many brokers, including most online brokers. If you want to own bonds but don't want the hassle of buying and selling them yourself, there is also a wide range of bond mutual funds available.

THE BOTTOM LINE: For long-range growth, you can't top stocks, so keep your portfolio tilted in that direction as much as you possibly can. When you need a little balance, or are getting closer to needing the money in your portfolio, add a small portion of bonds.