U.S. Treasury bonds are completely safe from default -- they are backed by the full faith and credit of the federal government. Your grandchild will never have to worry about receiving interest on time or the bond’s face value when it matures. However, default is but one of several types of risk. You might want to have your grandchild diversify her investments to increase the portfolio’s overall safety.
You can purchase Treasury bonds directly from the Treasury in multiples of $100 face value. T-bonds mature in 10+ to 30 years. Treasury notes are similar, except that they mature in one to 10 years. Normally, longer maturity bonds pay higher interest rates. The interest income from Treasury debt is free from state and local taxes. Treasury bonds and notes pay a fixed interest amount semi-annually. Because Treasury debt is free of default risk, it pays lower interest rates than do corporate and mortgage bonds.
Inflation robs bonds of their buying power. If your Treasury bond yields 2 percent while inflation grows at a 3 percent clip, your bond loses 1 percent of its buying power annually. You need not sacrifice freedom from default risk for inflation protection -- the Treasury offers two inflation-protected products that are default-risk-free. Treasury inflation protected securities, TIPS, receive additional principal payments to match changes in the Consumer Price Index. Series I savings bonds pay variable interest that is partially tied to the CPI.
When interest rates rise, the prices of outstanding bonds drop. If you hold a bond until it matures, you receive the face value without regard to prevailing interest rates. However, if your grandchild wants to cash in a 30-year T-Bond before maturity, price risk becomes a reality. You can reduce price risk by laddering your bond purchases. A bond ladder consists of bonds with a variety of maturity dates. The price of short-term debt is fairly stable and you can reinvest the payoff at maturity in new, higher-rate bonds. You might want your grandchild to hold some Treasury bills, which mature in less than one year and are free of default risk.
If interest rates fall, your bonds will gain value. However, you will not be able to reinvest your interest payments at their original rate without accepting higher risk. You can avoid reinvestment risk by purchasing zero coupon Treasury bonds, known as STRIPS. All of the bond’s accrued interest is paid at maturity -- you don't have to reinvest any interest payments. You must pay taxes on the annual imputed interest, but your grandchild might have have little or no tax liability, depending on her total income.
Capitalize on Youth
Since a young child has many years until retirement, you might want her to take a few investment risks. The power of compounding can diminish the damage of any missteps over a 40 to 50 year period. A diversified portfolio of stocks, bonds and other assets might outperform a portfolio consisting only of Treasury debt. If your grandchild opens a Roth individual retirement account, all earnings will be tax-free if distributed after age 59 1/2. You can also establish a custodial account for your grandchild’s benefit. Such accounts offer a tax-efficient way to make gifts to a minor.
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