When thinking of investing most people think stocks and bonds. Stocks can be seen as little pieces of the company, so anyone who owns stock in a company will own a little piece of the company. Bonds on the other hand are debts owed by the company. The US Government is no different, however, since people cannot really own a piece of the Government there is no stock involved. They do sell bonds however, and savings bonds range in values anywhere from $50 to $10,000.
How Bonds Work
When a company sells bonds, they are essentially asking for a loan. When someone buys bonds, they are lending money to that company. The loan has a term and an interest rate, and over time the company pays the interest until the bond matures and the company will pay it back in full. There are two ways bonds can be sold. At a discount with a low interest rate, or at par value with a higher interest rate. When the bond is sold at a discount, the owner will collect a smaller amount of interest per payment, but they will still get the full value of the bond at maturity. When a bond is sold at full par value, the owner will collect more in interest over time, but they will not get anything extra back when the bond matures. Confused? Take some time to learn about coupon, yield, and yield to maturity.
How Savings Bonds Work
Since the US Government does not sell stock, the only way to get more money (aside from raising taxes) is to sell bonds. Rather than make things more complicated than they need to be, every new bond is sold at half its value. Over the years the value of the bond will increase, while every year very little is paid out in interest. While corporate bonds are yielding a much higher rate of return, many people are shying away from savings bonds. But there are reasons why it is a good idea to purchase savings bonds.
The biggest reason people put their money in savings bonds is that they are safe investments. They are backed by the full faith of the US Government, so the only way they will expire worthless is if the government collapses. If that happens, you have a lot more problems to worry about than losing money on investments. Another big factor in these bonds is the tax benefits. While state and local taxes are still owed, the earnings from the bonds are exempt from federal taxes. The safety and tax advantages of savings bonds make them an important part of a diversified portfolio.
Savings bonds are a great tool. If a person has quite a bit of risk in their portfolio, these bonds can help to balance out that risk. But they are not for everyone. Those who have a long time horizon might be better served investing in something that has a higher rate of return. Like all investments, make sure you understand how they work before committing any money to them.