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A primer on Series I savings bonds

Although inflation has been sleeping for several years now, the tiger may be waking up. In some sectors of the economy, low unemployment is causing wage rates to climb. Global economic growth is lifting prices for raw materials and commodities. And a decade after the subprime mortgage crisis, the pressures that prompted the Federal Reserve to squelch interest rates are beginning to ease.

If you're searching for a hedge against inflation, Series I bonds are worth a look. They're sold by the U.S. Treasury and like EE bonds, interest on I bonds is exempt from state and local income taxes. Federal income tax on I bond earnings and interest isn't due until the bonds are sold. Every six months the U.S. Treasury computes I bond interest rates, which consist of two components: one fixed, one variable. The fixed rate doesn't change over the life of the bond. The variable rate is revised every six months based on the rate of inflation.

Like interest rates in general, I bond rates have declined significantly in recent years. For example, in May 2000 the fixed rate on I bonds was set at 3.6 percent and the variable rate was 3.89 percent, resulting in a compound rate of 7.49 percent. Because inflation rates fell over time (due mostly to declines in energy prices), I bond rates dropped as well. This year the Treasury set the composite rate for I bonds at 1.96 percent.

So if I bond rates have been declining, why would anyone want to purchase them? For one thing, there's the tax benefit, which is especially enticing if you live in an area with high state and local taxes. In addition, the government will revise rates upward if inflation heats up. Because the principal is not adjusted, I bonds won't depreciate from their face value. Another benefit: if you use I bonds to pay for college, the interest may be exempt from federal taxes.

On the other hand, I bonds are not as liquid as a money market account, for example. That's because I bonds can't be redeemed unless held for at least a year. If you sell before holding the I bond at least five years, you'll forfeit three months' interest.

For a deeper look at the pros and cons of I bonds, visit TreasuryDirect (www.treasurydirect.gov).

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