In terms of savings bonds, everyone is always hyping up the Series I Bond. No one wants to be left behind by inflation, so its become very common to fill up your $10,000 quota of them. Much less love is shown for its sibling, the Series EE Bond. But as we'll discuss in this article, for lots of common financial planning scenarios, EE-Bonds can be a very helpful tool to achieve your goals. To do this, we'll first have to understand the financial principle of duration matching.
Duration Matching
In the field of finance, as well its practical application to your life, one of the common things that can happen is that you have some amounts of money coming in at various points in time, and you need to spend some amounts of money at other points in time. This idea of having an output cash flow, and a cash flow hopefully funding it is obviously very general.
But that begs the question — How do you go about making sure you've picked an income cash flow that can fund your obligation? And more difficult: how do you ensure this will stay true in a world of constantly changing interest rates (which are what determine what your fixed income investments return).
The key idea is to look at a cash flow, and distill it down to a single metric, one that measures how its value will change with interest rates. A small caveat is that this number isn't usually quoted as a percent or anything. Rather, its quoted as a duration of time (hence the name duration). Here, if you have a duration of 10 years, that means you have the same sensitivity to interest rates as a zero-coupon 10 year bond (i.e. a single payment at 10 years, and no other payments before that).
Then, the strategy goes as follows. Take your output obligation cash flow and calculate its duration. Then, find an investment whose duration matches it. Now, if you buy enough of your investment in present value terms to equal the present value you need, you'll be good. Even if interest rates change the value of investment, it'll be exactly cancelled out by the change of value in your liability.
Aside: Convexity
Technically, just matching the durations is not actually enough. The issue is that initially, the two will respond the same to a change in interest rates — by the amount that their duration predicts. But then, if the interest rate changes too much their values might stop changing in concert. The complex ways in which a cash flow might respond to interest rates can't actually be distilled down to a single number without losing a lot of information. What we do when we quote a duration is talk about how this response looks like near the current interest rate.
One partial remedy is to also match another number, called the convexity. This describes how the duration itself changes with interest rates. Matching both lets you be more confident as interest rates get further from the value today. Mathematically, you can think of graphing your cash flow's value as a function of the interest rate. Then, the duration and convexity are variations on the first and second derivative.
You can find some examples of calculating durations in practice on Wikipedia.
Failure to duration match properly can be a serious issue. For example, consider the 2023 collapse of Silicon Valley Bank. It thought it was being safe by buying lots of US Treasuries — which have very low default risk. But it failed to consider that it had left a very bad duration gap between these long term inflows, and the short term outflows it owed its depositors. This meant it had taken on a lot of interest rate risk. When interest rates rose, the present value of the treasuries dropped a lot faster than that of its deposits, leaving it insolvent.
EE Bonds
Now, imagine that in 20 years you know you'll need a large amount of money for, say college (maybe you're trying for a child now). One thing you would probably try to do is start funding this need by putting money into some sort of investment. That way, the price tag for you would be cheaper than just saving up cash now.
If you buy short term bonds, you'll be facing reinvestment risk. Even if the interest rate on those bonds now, extrapolated across 20 years, lets you save up very cheaply, you don't know if that will stay. When they mature, who knows what the interest rate will be and what kinds of reinvestment opportunities you'll have. You might be stuck not being able to grow your money fast enough to pay for your child's college.
On the other hand, if your investment has a lifetime of more than 20 years — well the issue is obvious there. You simply won't get your money in time (Or if its an instrument you're planning to sell in 20 years, its value may simply drop too much if interest rates rise).
You can see where we're going with this — you want to duration match your investment.
Here's where Series EE Bonds come in. The US government has provided for individual savers, a bond that has exactly a 20 year duration, with at least a 3.52% interest rate. They don't phrase it like that of course. Technically, it has things like an initial and final maturity, an initial fixed rate, doubling of principal, etc. However, if you just always redeem it after twenty years, that's how it plays out. You can find the simple math here.
One thing to note is that a 20 year Treasury Bond does not have a duration of 20 years. As weird as it sounds, its duration is less than 20 years because of the coupon payments. This makes conceptual sense if you imagine it in the context of our college example. If you want to take full advantage of compound interest, you're responsible for finding some place to reinvest the coupons payments as you receive them every six months (and getting a good enough rate when you do so).
In general, if you have a need for a single sum of money in the future, then buying an EE-Bond 20 years before that is a perfect match of your liabilities and assets. This is where its power as a saving tool shines. Plus it doubles your money!
When trying to save and invest, one is often simply trying to maximize their wealth under risk. This is a very tempting, and usually the correct approach. Here is where ideas like buying index funds (best risk adjusted return), putting your cash in t-bills (they're basically cash but better because they pay x%), diversifying across asset classes (free risk adjusted return), etc. come from.
But on occasion, it may be worth it to stop and zoom out. Sometimes we do have specific financial goals for the future; specific needs we can plan for. Then, we can do better than just trying to maximize wealth. In this context, duration matching in general, and maybe EE-Bonds in specific could be useful tools to consider.