Series 1 Bonds Protect Against Inflation

By Dan Shepherd

Part 2 of investment options - Bonds

Last month we talked about Mutual Funds and how they work. This month I would like to talk about Treasury bonds. Many times bonds are misunderstood and viewed as a poor addition to your retirement portfolio. I believe you will look at bonds in a different light after further examination.

During the 1990s, when the stock market was roaring, inflation remained tame and only nibbled at investors' returns. But things look somewhat more threatening these days.

Unemployment is low, at just 4 percent. Facing a shortage of skilled workers, businesses might have to pay more and offer better benefits to lure and retain top employees. That could drive up wages and salaries. Moreover, these companies are feeling the pinch of higher fuel prices, which in the past were more reasonable. Businesses that are especially dependent on fuel, such as airlines and shipping companies, are raising their rates to compensate. This is not to say that we're going to return to years of double-digit inflation and lines at the gas pumps. In fact, if Alan Greenspan has his way, inflation will remain calm and the economy will stay healthy. However, as an investor, you shouldn't ignore the possibility that prices will rise rapidly at some point.

You can immediately help neutralize inflation's effects on your portfolio by purchasing "inflation-indexed" or "inflation-protection" US Treasury Series I savings bonds.

Here's how 1 Bonds work: A 3.6 percent annual interest rate currently applies for the life of the bonds, which can be as long as 30 years. This percentage is combined with a second one, which is adjusted semiannually and reflects the inflation rate for a trailing six-month period For instance, if you buy an I Bond before the end of October- you'll earn 7.49 percent annual interest for the first six months you own it-the fixed 3.6 percent, and the rest to cover the annualized inflation rate, as measured by the most recent six-month increase in the Consumer Price Index.

Unlike some government and corporate bonds, whose prices drop as interest rates rise, an I Bond won't fall in value below the face amount--and its Value could increase if the supply of these bonds dries up and investors begin to pay a premium for them. At the very least, your purchasing power will beat the rise in the CPI by 3.6 percent, the fixed portion of the bond's rate.

Series 1 Bonds do have a few potential pitfalls

* If the economy experiences a period deflation rather than inflation and prices flatten or decline, an inflation-indexed bond will earn less than a regular Treasury bill.

* If you redeem a Series 1 Bond within five years after buying it, you'll pay a penalty equal to three month's earnings.

* You won't get a penny of interest-either the fixed rate or the inflation adjustment-until after the bond matures or you sell it. So if you're looking to generate current income, better look elsewhere.

Earnings on a series 1 Bond are exempt from state and local taxes, but you must report the income on your federal tax return. You can do this in one of two ways: each year as the interest accrues, or all at once when the bond matures or you redeem it. That means you can take a series of little hits or one big hit which could be quite substantial, depending on how long you own the bond. If you don't specify a method of reporting this income, the IRS assumes all taxes will be deferred.

To order 1 Bonds commission-free, go to the Web site of the US Bureau of the Public Debt (www.publicdebt.treas.gov). Under "savings bonds," click on "savings bond connection." Or you can buy them through most banks at no charge, up to $30,000.00 worth per person per year.