I have a question about bonds and savings accounts.?

Question

I am trying to save money for college and was wondering whether to get a cd savings account at a bank or to buy government stocks? I have seen the interests rates and government bonds are way better. But if they have such a better interest rate why does everybody just buy them? What are the risks and rewards of both?

Answer 1

You think the interest rate on government bonds is way better?  Which bonds and what government were you looking at?  A 10 year U S treasury note is priced to yield about 4%.  You can get a 5 year cd that yields about 5%.  There are risks to buying both especially with the longer term CDs and government debt.  The risk is that interest rates will increase and the principle value of the CD or government paper will drop.  Currently, the government is in bail out mode and they have reduced interest rates to negative levels to help out their buddies on Wall Street and all the real estate speculators.  That will have to end eventually.  When it does interest rates will increase and long term paper will lose a significant portion of its value.  Now if you go with a short term CD you can protect yourself against the rising interest rates, but short term CDs yield about 2.5%.  U S government T-bills also short term yield about 1.9%.  There is a certain tax advantage to buying U S government paper.  It is not taxed by state and local units whereas CDs are.   Keep in mind that inflation is currently running about 6% according to government statistics.  It is probably actually running about 8%.  

Answer 2

One issue is liquidity. You must hold the gov savings bonds for a certain period before you can cash them in. Be sure and find out the miniumum holding period.

But it definitely can happen that the gov gives you better rates than banks. Years ago I remember getting some savings bonds thru a bank; the bank tried to get me to purchase one of their CD's instead but they couldn't match the US gov rate.

Watch out if you're considering gov bonds sold thru a broker. The spreads can be poor for the small investor.

And do NOT buy a bond mutual fund, since you can lose your principle. The interest rate can sound good, but if interest rates rise your principle will fall.

Since you're saving for college, look in to whether there are tax advantages in saving toward such a goal. And if state taxes are an important issue with you, any US gov issue is not subject to state income taxes.