PERSONAL FINANCE
When investing in bonds, don't put I before EE

By Sandra Block
USA Today

If you buy a $10,000 I Bond, you'll receive a bond depicting Hawai'i's Spark Matsunaga, a Japanese American war hero who received the Bronze Star and two Purple Hearts during World War II.

For $200, you can buy an I Bond featuring Chief Joseph, a courageous Native American leader who led the Nez Perce tribe.

I Bonds' principal is adjusted for inflation, and they're virtually risk free. But if you're looking for a decent return on your investment, you may want to give them a pass, at least for the next six months.

The Treasury recently adjusted the interest rate on I Bonds to an annualized rate of 2.57 percent. A year ago, I Bond investors were earning close to 6 percent. The stingy rate reflects two developments:

• Negligible inflation. I Bonds are linked to inflation, with rates reset every six months. Consumer prices have remained stable, prompting the Treasury to add just 0.57 percent to the bond's principal.
• A low fixed rate. The second, and potentially more powerful component of the I Bond is the fixed rate. Unlike the inflation rate, the fixed rate in effect when you buy stays in place as long as you own your I Bond. Last November, the Treasury knocked the fixed rate back to 2 percent from 3 percent. If you purchased an I Bond after Oct. 31, or invest in one now, you're stuck with the 2 percent rate for as long as you own your bond. Which means inflation will need to heat up considerably before you'll start earning pre-November returns.

When contemplating an investment in an I Bond, "The fixed rate is the most critical thing," says Daniel Pederson, president of Savings Bond tracker BondHelp.com.

If demand for I Bonds falls significantly, the Treasury may increase the fixed component when it adjusts rates again in November, Pederson says. But so far, that's not happening. The Treasury is selling about twice as many I Bonds as EE Bonds, he says.

Many investors in I Bonds buy them automatically through payroll deductions and don't pay much attention to interest rates. But that's a perilous way to invest. Locking in the lower rate could cost you thousands of dollars over the life of your bond.

A better strategy for Savings Bonds fans: Invest in the EE Bond, a reliable war horse that lost its luster after I Bonds were introduced. Now, the EE Bond is paying 3.96 percent, down from 4.07 percent in November. The interest rate for EE Bonds is reset every six months, based on 90 percent of the average five-year Treasury notes.

Unlike I Bonds, the rate on EE Bonds isn't adjusted for inflation. But when inflation edges higher, interest on Treasury notes tends to move up, too, Pederson says. Based on an analysis of interest rates over the past 12 years, Pederson believes I Bonds need a fixed rate of 2.6 percent or more to outperform EE Bonds.

A 3.96 percent rate isn't going to make you rich. But it's more than you'll earn on most money market funds and short-term certificates of deposit. Other advantages:

• Interest is exempt from state and local taxes.
• Federal tax on interest is deferred until you sell your bond. If income tax rates continue to fall, or you're saving for retirement, you may be in a lower tax bracket when you cash in your bond.
• You can buy an EE Bond for as little as $50. The maximum you can invest is $15,000 a year, per person (the maximum for I Bonds is $30,000 a year).

There are down sides, too. Unlike a money market fund, which can usually be cashed in at any time without penalty, you can't withdraw your money from a Savings Bond for the first six months. And if you withdraw money during the first five years, you'll give up three months in interest.

But Pederson says higher returns from an EE Bond may outweigh the early withdrawal penalty. If you buy an EE Bond and sell it after a year, for example, the penalty will reduce your interest to just under 3 percent at current rates. That's still better than most other short-term, low-risk investments. And the impact of the penalty declines each year during the five-year period.

After Sept. 11, Congress passed legislation directing the Treasury to issue a new war bond to help the war against terrorism. The Treasury's response was to rename the EE Bond the Patriot Bond. The bond is identical to the EE. The new bond just has the words "Patriot Bond" on the front.

It's still not nearly as eye-catching as the I Bonds. But for the next few months at least, the EE will deliver more appealing returns.