Academic journal article Financial Services Review

The Economics of Savings Bonds

Academic journal article Financial Services Review

The Economics of Savings Bonds

Article excerpt

Abstract

Series EE Savings Bonds have provided floating rate returns since 1982. They also contain valuable embedded options, including an early redemption option, a guaranteed minimum rate option, and a tax-timing option. Our analysis indicates that the simulated risk-return performance of Savings Bonds has been relatively attractive compared to other default-free assets. Thus, Savings Bonds appear to be worthy of consideration by individual investors. Our regression analysis indicates that, over the 1990 through 2001 period, investors considered both interest rates and economic conditions in their EE Savings Bond purchase and redemption decisions. © 2004 Academy of Financial Services. All rights reserved.

Jel classification: E21; Gl 1

Keywords: Consumption; Saving; Portfolio Choice

1. Introduction

Savings Bonds, sold by the U.S. Treasury since 1935, received a dramatic "makeover" in 1982: the coupon rate on Series EE bonds began to float with the market rate on ordinary Treasury notes and bills. Before this change, it was widely assumed that EE bonds offered unattractive returns and that investors should generally avoid them. However, even in their present configuration, which along with floating rates includes several embedded options that add value, there has been no examination of their returns and risk relative to other securities, or to the factors that motivate individual investors to purchase them.

In this paper, we have two main objectives. The first, which is of particular interest to individual investors, is to examine how Series EE U.S. Savings Bonds' return and risk compare with other default-risk free securities. The second is to determine whether the demand for Series EE Bonds, which unlike most other securities, can be held only by individuals, responds to interest rates and other economic variables.

In section 2, we review the history of the U.S. Savings Bond program. In section 3, we describe the characteristics of current Savings Bonds, and describe the options embedded within them. In section 4, we compare the performance of alternative instruments to a simulated security possessing the same features as current Series EE Bonds. In section 5, we present empirical findings on the relationship between the demand for Series EE Bonds and interest rates and other economic variables. Our conclusions are in section 6.

2. History1

U.S. Savings Bond sales began in March of 1935, ". . . at a time when people's incentives to save-as well as their confidence in financial institutions-had been shaken by the pain of the Great Depression. . . " (Linehan, 1991). One objective of the program was to broaden the base of public debt by attracting small investors. Designed to be attractive to individual investors, the bonds were sold in small denominations, at a fixed interest rate. A key feature was that they were redeemable after a short period of time, at the purchase price plus accrued interest, eliminating price fluctuations. Another desirable feature was that federal income taxes could be deferred until redemption. Additionally, bonds were issued only in registered form, replaceable in case of loss.

Series A through D bonds sold in relatively small amounts through April of 1941, when a new "Defense" Savings Bond, the Series E, was introduced.2 After the attack on Pearl Harbor on December 7, 1941, Savings Bonds sales soared, along with other forms of public debt. Sales rose from $2.5 billion in 1941 to $16.0 billion in 1944, and the proportion of the privately held portion of the public debt comprised by Savings Bonds rose from 6.8% in 1940 to 25.4% in 1951.

Savings Bond sales fluctuated moderately over a $4 to $5 billion range over the period from the 1950s through the 1960s, reaching a postwar peak of almost $8 billion in 1978. However, EE yields failed to follow interest rates during the inflationary period of the late 1970s and early 1980s and sales dropped to just $3. …

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