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Understanding Savings Bonds

Updated on September 8, 2009

Savings bonds are debt obligations issued by governmental bodies to tap the savings of individuals. To make these securities as attractive as possible to the general public, governments usually sell them in small denominations and at many locations. Savings bonds often offer especially attractive terms not made available to purchasers of other securities offered by the same government. For this reason, savings bonds often are not eligible for purchase by commercial banks or other types of financial institutions.

Why Bonds Are Issued

When a government is eager to induce individuals to purchase savings bonds, it is almost always attempting to avoid inflationary pressures on the economy. A government borrows money because its level of spending has exceeded the amount of revenue obtained through tax collections. If the government can attract the savings of the populace into purchase of government securities, then savings already in the hands of the public will be turned over to the government and will finance the deficit:  the gap between the level of government spending and the amount of tax collections.

If the savings of the public cannot be tapped, the deficit nevertheless must be financed, because the government must pay for all the goods and services it has purchased. In such a case, the government must either print new money or borrow from financial institutions. Often the only way the government can borrow from financial institutions is by allowing the commercial banking system to create new deposit money and pay for the government bonds with this newly created money.

Whether the government prints new money or borrows newly created money from the commercial banks or from the central bank, the final result is the same, because more money has been created. If the nation is not able to increase its output of goods and services, this increased money supply will lead to price and wage increases and inflationary pressure. Thus governments try to finance their deficits by borrowing from the public as much as they possibly can in periods when the economy is near capacity operation and cannot expand its output: a condition that occurs, for instance, in wartime.

Advantages and Disadvantages

To the public, the advantage of savings bonds is usually their high degree of safety. Because they are guaranteed by the government, they are as riskless as the nation's currency itself. Generally they are offered with terms for repayment fixed in advance so that the buyer is sure of the redemption value if he needs to get his investment money back before the bonds mature.

In some cases, however, because the amount of repayment has been determined in advance and because the amount of interest income paid has been fixed, savings bonds have failed to attract the public. Rising prices and pressures of inflation make fixed-income securities unattractive to savers, because the amount returned on maturity (even with interest added) often buys fewer goods and services than the money originally invested could have purchased at the time the securities were bought. Therefore some nations have issued savings bonds whose redemption value and interest are not fixed in advance, but are tied to some other item that reflects changes in the value of the currency over time, such as a cost-of-living index, the price of gold coins, or the cost of electric power. Britain has had savings bonds on which no interest is paid. Instead, all the interest that would accrue to holders of the bond issue is pooled and then distributed to the winners of a lottery in which only these savings-bond holders participate.

Because tapping the savings of the public is often so important to a nation's economic stability, the promotional efforts devoted to selling savings bonds often exceed those connected with the sale of all other government securities.

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