2. I savings bonds (I bonds)
How they work: I bonds are a better hedge against inflation than plain-vanilla bonds because they're designed to keep pace with rising prices.Specifically, the bonds pay a composite interest rate that's made up of two parts, an underlying fixed rate and an inflation-adjusted variable rate. The variable interest portion is tied to the CPI rate, the government's measure of inflation, and rises and falls during the life of the bond to keep pace with prices.
The fixed rate portion remains unchanged for the life of the I bond. This rate changes semiannually, on May 1 and Nov. 1, for newly issued bonds.
Currently, I bonds are paying a composite rate of 4.84 percent. On May 1, the underlying fixed rate was set at zero percent, and the semiannual inflation rate was set at 2.42 percent. These rates will change again on Nov. 1.
"The fixed rate amount of zero percent is the lowest ever," says Stephen Meyerhardt, spokesman for the Treasury Department. "That's because the fixed rate reflects the underlying conditions of the short-term credit markets, where rates have dropped precipitously in the last six months."
The semiannual inflation rate actually rose, to keep up with an uptick in inflation. That means the current composite rate isn't at an all-time low. On the other hand, that's not to say investors should ignore the fixed rate. Because it will remain unchanged for the life of the bond, anyone who buys I bonds in the next six months, before they're reset in November, needs to be careful.
"They're OK if you want to keep pace with inflation, but if your objective is to outpace it, these aren't so good" right now, says Meyerhardt.
Cost: I bonds can be purchased electronically in amounts of $25 or more, or for a minimum $50 for paper versions, from Uncle Sam at www.treasurydirect.gov.
Liquidity: I bonds are not very liquid. You cannot redeem I bonds for 12 months, and if you sell before five years, you'll forfeit interest from the three most recent months. To avoid penalties, you must wait five years to cash out.
Pros: Safety and inflation protection. Generally bonds won't pay you the handsome returns of stocks. The upside? The principal is guaranteed.
Tax perks: I bonds are exempt from state and local taxes, and investors can defer what they owe in federal taxes until they cash them in.
Cons: Limited growth. Even though you beat inflation, I bonds generally won't have the kind of growth as riskier investments. Lack of liquidity is also a negative.
Who they're good for: Retirees who already have a hefty nest egg and therefore don't need as much growth should look to I bonds. "I bonds can work for people who've worked hard for their savings and who want more capital preservation since they provide capital preservation as well as a bit of income," says Morningstar fund analyst Paul Herbert.