FAQ about savings vehicles
By Bankrate.com

Diversifying your portfolio with solid savings vehicles is a wise financial strategy. Everyone's situation is different, but here are some frequently asked questions from Bankrate's virtual mailbag, with answers from our experts, Dr. Don and the Dollar Diva.

Do Series-I savings bonds belong in my portfolio?

Why would I want to invest in bonds?

How fast do bonds grow?

What are zero coupon bonds?

Which is the better savings vehicle: treasury bills or CDs?

Are the Series-I bonds a good investment vehicle for some of our savings?
If you're on target with your stock fund investing, then it's time to put your extra money in bonds.

Bonds are less risky than stocks, but there is some volatility. Most of them react to changes in interest rates; when interest rates go up, bond values go down, and vice versa. Not so with I-bonds. If the face value of your bond is $1,000, you will never receive less than $1,000 when you redeem it. Here are some other good reasons to invest in I-bonds:

• Zero risk. I-bonds are savings bonds backed by the U.S. Government.
• Indexed for inflation. Interest is a combination of a fixed rate (never changes) and an inflation rate (goes up or down semiannually, depending upon the Consumer Price Index). The current combined rate is 4.66 percent, of which 1.10 percent is fixed.

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• No transaction fees. Buy them directly from the US Treasury online, or from your local bank or credit union.
• Eight denominations: $50, $75, $100, $200, $500, $1,000, $5,000, $10,000.
• Tax-deferred up to 30 years. No federal income tax is paid until the bond is redeemed.
• Tax-exempt from state and local taxes.
• Education Savings Bond Program. Use the proceeds for college tuition for yourself, your spouse or dependent, and the interest may be tax free. See IRS Publication 550, Investment income and expenses, for details.

For a comparison of I-bonds and EE bonds see the U.S. Treasury's Web page "What's the difference between I bonds and EE bonds?"

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What is the rationale for putting money into bonds if I plan to hold the portfolio at least 10 years?
Over the long haul, you can expect a portfolio of 100 percent stocks to outperform a portfolio of stocks and bonds. But it's not a sure thing. The Diva doesn't think 10 years is a long enough haul to take that gamble.

Who knows what investments are going to rule over the next 10 years? When you're 25 years old, you can be as aggressive as you want. Nearing retirement, it makes sense to hedge your bets with some bonds.

Bonds are less risky than stocks, especially Treasury bonds. If you buy a $10,000 Series I savings bond from the US Treasury, it's never going to be worth less than $10,000. And I-bonds are adjusted for inflation every 6 months.

Stocks just aren't paying the dividends they used to. If you need an income stream, bonds will give it to you. Folks in a high tax bracket favor municipal bonds; there's no federal tax on the interest.

The rationale for adding bonds to your portfolio is to make it safer. Playing "comeback kid" is a tough act for a retiree who has lost her bet on the bull market.

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I have some Series EE U.S. savings bonds. Will I only get face value, or do they keep growing? What should I do with them?
Your Series EE Savings bonds will continue to grow until their maturity date. If you cash in the bond, you'll pay taxes on the amount of interest you've earned to date on the savings bond.

The U.S. Treasury's savings bond calculator is a user-friendly tool that will help you figure out what the bonds you currently hold are worth. It will also give you the interest rate, year-to-date earnings and next accrual date.

Series EE bonds will stop earning interest after their maturity date, so you want to cash them in before that; but there's no rush. Here are some of the things you want to consider before you do:

• Your savings bonds are earning tax-deferred interest. If you're in a high tax bracket now and expect to be in a lower bracket before their maturity date, you may want to hold them until your tax rate goes down.

• The interest is included in your adjusted gross income the year you redeem the bonds. If you have a lot of them, it could push you into a higher tax bracket, trigger tax on Social Security payments or prevent you from making an IRA contribution. You may want to consider spreading the redemptions over a few years.

• When you decide to cash them in, do it just after an accrual date rather than just before. Newer bonds accrue interest monthly so it's not an issue, but older bonds accrue interest twice a year.

• The US Treasury's savings bond calculator will tell you the interest rate your bonds are currently earning. If it's better than what you're getting in your money market fund or certificates of deposit, keep the bonds as liquid, short-term savings securities.

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What are zero coupon bonds?
Bond talk can sound like a foreign language, so let's start with some definitions:

Bond: When companies or governments borrow money from an investor, they give the investor a debt security called a bond. The bond is a piece of paper, much like an IOU, that states what the interest rate is and lays out the other terms of the loan.

Coupon: A coupon is the interest or interest rate you receive on bonds. Bonds used to come with small, detachable coupons. They usually pay interest twice a year, so every six months most bondholders would clip a coupon and redeem it for the interest due.

Today, bond interest is usually paid through electronic transfer, but old habits die-hard. Even though you're as likely to run into a Tyrannosaurus rex as you are of finding little coupons attached to your bond, the bond's interest and interest rate is still referred to as it's coupon.

Zero: (You guessed it.) None.

Face Value: The value of the bond at maturity. If a bond with a $1,000 face value matures on Dec. 31, 2005, you will receive $1,000 on that date. It doesn't matter if interest rates are up or down or if NASDAQ is flying or in the sewer. Unless the borrower defaults because it doesn't have any money, you will receive the face value of your bond on its maturity date.

Maturity date: The date you are entitled to receive cash equal to the face value of your bond.

Discount: Difference between a bond's price and its face value. If you buy a $10,000 zero coupon bond for $5,000, you are buying it at a deep discount. The discount, in this case $5,000, is actually the interest that will accumulate during the life of the bond.

A zero coupon bond is a bond that is bought at a deep discount from its face value. It pays zero interest during the life of the bond, but pays the full face value on the bond's maturity date. Most people buy zeros issued by the U.S. Government or state and local municipalities.

The zero provides the comfort of a secure investment. If you buy a non-callable zero -- one that the issuer cannot make you redeem before the maturity date -- you have a sure thing if you hold the bond to maturity. Most Treasury and municipal zeroes are non-callable.

If you need $10,000 in three years for school tuition, or $30,000 in seven years to pay off a mortgage, the non-callable zero will get you there. But to find the comfort level, you need to be sure you're not going to have to cash it in before its maturity date.

If you need to cash the bond prematurely, you will be selling it on the open market in competition with new bonds that may be cheaper.

Remember that $10,000 zero coupon bond bought at deep discount for $5,000? Well, the reason it cost $5,000 was the interest that would accumulate before maturity was worth $5,000. There's your $10,000 face value.

If interest rates have climbed since you bought it, then the interest on a new bond will be more than $5,000, which drops the purchase price below the amount you paid. If you sell your bond, you may lose money.

Someone who can buy a new bond for $4,000 is not going to buy your bond for $5,000, even if that is what you paid for it.

If you like to gamble and think interest rates are going down, the zero will give you a thrilling ride if you win. But you'll get a big headache if you lose.

If you buy municipal zeros, you're spared the federal tax that is levied on Treasuries for each year's imputed interest.

Investors who buy Treasury zeros often get around the tax disadvantage by putting them in tax-deferred retirement accounts, like an IRA, or the kids' accounts, if the children are in a low-to-no income tax bracket.

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T-bill interest earnings are exempt from state and local taxes, but interest income from CDs and money market funds aren't. So, at any particular time, how does one decide which saving vehicle is the best?

5.89 percent x (1.00-.36) = 3.77 percent

6.00 percent x (1.00-.36-.08) = 3.36 percent

6.00 percent x (1-.36-(.08x(1-.36))) = 3.53 percent

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-- Updated: May 1, 2003