Monday, November 14, 2011

Extreme EE Savings Bond Mispricing

The government is officially asleep at the EE Savings Bond wheel.

Although the government has set the short-term interest rate of EE Savings Bonds at just 0.6% it has not altered the original term (the time needed for the bond to double in price). That's still set at 20 years and if held that long the bond will yield 3.53% per year.


2^(1/20) = 1.0353


Click to enlarge.

The chart above compares the EE Savings Bond rate if held to original term (the time needed for the bond to double in price) to the rate of a treasury bond with the same duration (using interpolation on the treasury yield curve where needed).


Click to enlarge.

The chart above shows the rate markdown of the EE Savings Bond compared to a treasury bond of the same duration. That tends to be about 30%. Put another way, if the treasury bond yields 10% then the savings bond tends to yield about 7%. If the treasury bond yields 5% then the savings bond tends to yield about 3.5%.

The lower rate is due to the tax advantages that EE Savings Bonds offer (deferral of taxation, tax benefits for education).

As of today, the EE Savings Bond has an original term of 20 years. It therefore yields 3.53%. A 20-year treasury bond currently only yields 2.77%. As seen in the second chart, the mispricing between the two is currently at an extreme. What was once a premium to own EE Savings Bonds is now a discount.

So what does this mean?

In theory, if trading fees and taxes were absent then one could make risk-free money for 20 years by shorting $5,000 in 20-year treasury bonds while simultaneously buying $5,000 in EE Savings Bonds. The government would basically be paying you each and and every year for the next 20 years to do the trade (much like what it is doing for our biggest banks).

Or alternatively, I can't say that EE Savings Bonds are a good value to other things one could invest in, but it is clear that they are a good value relative to treasury bonds in general. Since I am generally a fan of relative value, that means I will probably be a buyer of EE Savings Bonds in 2012. That will make the 3rd year in a row. Go figure.

EE Savings bond rates and terms will not be changed again until May 1, 2012. There's no hurry to make the purchase though. In fact, it would probably be best to wait until April to make the decision. If the mispricing is gone in April it would only mean that interest rates on 20-year treasury bonds have risen dramatically. Who knows? It could happen.

Something will eventually fix this mispricing. That's about all I am sure of. I expected at least some of it to be fixed on November 1, 2011.


October 20, 2011
EE Savings Bond Rate Prediction for November 1, 2011

The government doesn't just set the interest rate. It also has the power to change the time it takes for a given EE savings bond to double in price. Since interest rates have fallen substantially, the odds of a duration change (for new purchases) are increasing substantially.

It would not surprise me to see the original term increase to 22-25 years at some point (perhaps very soon).


Source Data:
Treasury Direct: EE/E Bonds Rates & Terms
U.S. Treasury: Daily Yield Curve
St. Louis Fed: 5-Year Treasury
St. Louis Fed: 7-Year Treasury
St. Louis Fed: 10-Year Treasury
St. Louis Fed: 20-Year Treasury
St. Louis Fed: 30-Year Treasury

8 comments:

fried said...

It also has the power to change the time it takes for a given EE savings bond to double in price.

Mark,
have they ever changed the duration of the doubling on existing ee bonds?
I remember the 80s, when buyers of ee bonds were generally considered suckers. Or, more politely, unsophisticated investors. How the karmic wheel has turned.

Stagflationary Mark said...

fried,

have they ever changed the duration of the doubling on existing ee bonds?

As seen in the link I provided...

At a minimum, the U.S. Treasury guarantees that an EE Bond's value will double after 20 years, its original maturity, and it will continue to earn the fixed rate unless a new rate or rate structure is announced.

It wouldn't be much of a "guarantee" if they didn't honor it. That's not to say that they can't and won't alter the terms for new purchases though.

Further, it is far easier to modify the meaning of the word value. If the CPI triples over the next 20 years but the dollar value of the bond merely doubles, well, you know. It doesn't even take a brave politician to do that either.

I think the risks of the government altering the terms of the I-Bonds that I bought in 2000 (which continue to earn 3.4% above inflation) are also extremely low.

There would be no real point to doing so. The money saved by shafting me would pale in comparison to the money lost to future investors (rational ones would clearly opt out after seeing what happened to me).

tj and the bear said...

Since I am generally a fan of relative value

Only in terms of government issued paper, of course. ;-)

Stagflationary Mark said...

tj and the bear,

Only in terms of government issued paper, of course. ;-)

Hey, that's not true!

I did own gold and silver from 2004 to 2006 (back when it was much cheaper relative to toilet paper). It was a full third of my investment nest egg. They treated me quite well (50% gain). In hindsight, they could have treated me much better but they did all I asked of them and more.

And let's not forget how well my garbage bags are doing (up about another 20% since that picture was taken)! It is almost like garbage bags are made of petroleum products.

The relative value gods have shined down on me. ;)

tj and the bear said...

Should I have qualified that with "lately"?

That 3.53% yield may sound good to you (especially when your expectations have been firmly anchored so low) but have you noticed that the annual inflation rate has been running higher than that ever since May?

http://inflationdata.com/inflation/inflation_rate/currentinflation.asp

Stagflationary Mark said...

tj and the bear,

Had I been tempted to make long-term investment decisions based on just 5 months of inflation data in the past then I might have bought oil at $145 per barrel in the summer of 2008. Just a thought.

That said, I do respect what inflation can do or I would not be heavily invested in long-term inflation protected treasuries and inflation protected I-Bonds.

It is good that we can still debate inflation/deflation, for that offers more than a small amount of hope that I will not be financially ruined by hyperinflation within my lifetime. I've been bearish 7 years. Assuming I live to 80, there's only 33 years left to go. So far, so good! ;)

dearieme said...

These strange phenomena are international. Back in June, Index-Linked Gilts (corresponding to your TIPS) maturing in 2016 were yielding (from memory) about negative 1% p.a. in real terms. So the government's savings scheme cheerfully issued tax-free 5-year savings certificates yielding positive 0.5% p.a. in real terms.

What's a chap to do but fill his boots?

Stagflationary Mark said...

dearieme,

So the government's savings scheme cheerfully issued tax-free 5-year savings certificates yielding positive 0.5% p.a. in real terms.

It really makes one wonder, doesn't it?

Part of me thinks that the government doesn't want to rile up the savings bond herd.