How do Savings bonds work now a days?
I live in Massachusetts and would like to buy a savings bond for a friend's newborn. How does it mature in today's day? Does it go by the interest we earn now, or is it higher because it's a bond. Any information or advice on this would be awesome. Thanks a lot!
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Answer by John W
The interest that a bond pays is not like the interest that a savings account pays, for one it's a simple interest not a compounding interest and consists of detachable coupons redeemable for set sums on set dates. A bond has a face value for which it's redeemable for at maturity and it has the detachable coupons which are the interest payments that it will pay and is based upon the face value of the bonds, these are set contractually when the bond is created however the price at which the bond will sell for depends on the market condition hence if the prevailing interest rate is higher than the coupon rate of the bonds, the market price of the bond will be at a discount in order to give you the equivalent yield. There are even zero coupon bonds which do not make any interest payments what so ever and all the money is made off the difference between the face value at redemption and the purchase price. The market defines the price at which you can buy the bond at and what price you can sell the bond at leading to the paradox that if you buy a bond and the prevailing interest rates goes up, the price at which you can sell the bond at will go down such that you can lose money on the bond if you decide to sell it at the market prior to maturity, if you hold it till maturity, you only lose the opportunity value of the money. It's common to be able to achieve higher "yields" than with savings account but not because they are bonds but because they are long term investments of a defined period of time and the only way to "withdraw" money early would be to sell them to someone else. You should probably get yourself an introductory book on investing to learn about the various types of investments that are available.
As a gift to a child, you're looking at a 10 to 20 year bond so you should probably consider Treasury Bills as the government is likely to still be around in that time, the average life expectancy of a company in the S&P 500 is 12.5 years so corporate bonds probably entail too much risk over such a timeframe. If your intent is to not allow the child access to the funds till the bond matures, consider zero coupon bonds which are usually made by a third parties (re.: brokers) "stripping" the detachable coupons and selling the coupons and the certificate separately. The interest payments in terms of coupons represent income at regular intervals and if you're not actively reinvesting those payments, they represent a loss in terms of the opportunity value of the cash flow whereas a zero coupon bond will realize it's yield purely through capital gains effectively reinvesting the yield and compounding the investment.
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PJ Bond @ Fest 11 10.27.12-35
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PJ Bond plays Fest 11 at Civic Media Center, Gainesville, FL, October 27, 2012.
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