The true return of a Series EE Treasury Bond

My grandmother gave me a $100 denomination series EE treasury bond for every Christmas and birthday. These semi-annual bonds helped to illustrate to me both the concept and power of delayed gratification and investing. Today, however, I have many more vehicles at my disposal by which to invest. This begs the question -- is it worth it to keep the bonds, or is it more prudent to cash them and invest in another manner?

An EE series bond works as follows: an initial deposit of half the denomination buys a bond with a given interest rate. Once the bond reaches maturity -- mine have a 30 year time span, but various durations exist -- the initial deposit is matched. So we know that we will profit from the interest accrued AND the match. One crucial piece of information is omitted, however, which is the annualized return, taking into consideration both elements.

If we assume that some other vehicle of investment yields the same return annualized, then we can determine that the "true" return is equivalent to:

where r is the interest rate printed on the bond (APY), and t is hte number of years from the issue date to maturity.

Assuming a 30-year maturity, the "true" rate as a function of the printed rate becomes:

As we can see, the bond won't even outpace inflation (estimated at 3% yearly) unless the printed return is at least 1.2%. Further, it is worth noting that this is only the case when the bond is held until maturity. It is NOT worthwhile to monitor the performance of other investment vehicles and cash the bonds if it becomes unsatisfactory. For this to be a meaningful investment, we must know 30 years in advance that: (1) we will not need this liquidated, and (2) we are comfortable with not only the current rate of inflation, but also all the annualized rates of inflation for the next 30 years.

This does not even take into consideration the tax drag. It bears stating that the gain of the bond (what we earn in excess of half the denomination) is taxed as income in the year in which we liquidate the bond. To this end, here are the break-even rates (in terms of purchasing power) for each marginal tax rate:

Apparently, our earlier evaluation was inadequate. We now must consider too: (3) what our income will look like 30 years in the future, and (4) how the tax brackets may change in that time.

If you are considering buying bonds -- make sure that the yield is high enough that it will outpace inflation, even with tax drag (see above table), and that you are compensated beyond this by at least a percent annualized. For me, I would not buy an EE series bond with a printed return less than 3%, and even then, I would not have in excess of 5% of my entire portfolio in physical bonds (rough estimate of risk-adjusted optimization). Honestly, it seems much better to invest in a bond fund -- greater flexibility and potential returns, even though there is slightly more risk.

If you have been gifted EE series bonds, I would, barring major changes in income, sell any bonds yielding less than those shown in the table, for the appropriate income. The further you are away from maturity, the greater opportunity cost there is associated waiting to liquidate. Obviously, if you are closer to maturity, it would be more worthwhile to wait until the match to liquidate.

Assuming a 7% annualized return in an alternative investment vehicle, what is the printed return necessary to make keeping the bond more profitable? The following table investigates this:

From this table, we can conclude that the opportunity costs are pretty great considering the differences in expected return. Obviously, the 7% return is not assured, so within 1-4 years of maturity, I would say that from a risk perspective, it is almost always better to wait. (Note that the tax drag is assumed to be identical between the investments.)