09:42 PM EST on Friday, November 11, 2005

By NEIL DOWNING / The Providence (R.I.) Journal

We're all supposed to tuck away a little bit of money for emergencies, a reserve fund we can tap to cover the unexpected -- a big car repair, for instance, or maybe a leaky roof or a broken hot-water heater.

Where's the best place to stash that cash? Consider U.S. Savings Bonds -- specifically, Series I bonds.

You know they're safe -- they're issued and backed by the U.S. Treasury. You can buy them easily, at many banks and credit unions or online at:

www.treasurydirect.gov

You can buy them even if you have only a small sum to invest: For paper Series I bonds, the minimum investment is $50; for electronic Series I bonds (bought online), the minimum is $25.

And they're reliable. Series I bonds are designed to help your money keep pace with inflation, to protect the purchasing power of your dollars. So if you buy a $100 Series I bond today, for instance, you know you'll get at least that much when you cash it in -- and a bit more, when you take into account the interest your bond earns.

And one reason I'm focusing on Series I bonds now is that they're earning a lot in interest. If you buy one between now and May 1, it'll earn interest at an annualized rate of 6.73 percent for the first six months you hold it.

That's about twice the average yield nationwide on one-year certificates of deposit (CDs), and around 2 percentage points above the average yield nationwide on five-year CDs, according to Bankrate.com, a Florida company that tracks interest rates.

Before you jump in, however, there are some points you need to keep in mind. Perhaps the most important is this:

Although new Series I bonds are now earning interest at an annualized rate of 6.73 percent, you're not going to get that yield forever, said Daniel J. Pederson, president of The Savings Bond Informer Inc. of Detroit, which prepares customized reports on bond-holdings for savings bond investors and financial advisers.

Why? Think about how Series I bonds work. They really earn two rates of interest at the same time: one is a fixed rate, which stays with your bond for its entire 30-year life; the other is a variable rate, which changes every six months, with inflation.

If you buy a Series I bond today, it'll earn a fixed rate of 1 percent for as long as you hold it. It'll also earn a variable rate that changes with inflation.

It's the variable rate, not the fixed rate, that gave Series I bonds such a big bump up Tuesday, when the Treasury published the overall interest rate on Series I bonds.

That new variable rate is 5.70 percent on an annualized basis. It reflects the huge jump in inflation that occurred between March and September (mainly because of soaring energy costs).

Remember, though, that a new variable rate is set every six months, each May and November. So if you buy a Series I bond this month, it'll get a new variable rate in May 2006, another in November 2006, and so on.

Those future variable rates may be higher -- or lower -- than the one that kicked in Tuesday, Pederson said. If inflation falls, the next rate your Series I bond earns will be lower than what it is now.

For example, if it turns out that inflation runs at only 1 percent in the coming months, a Series I bond you buy today will earn interest at an annualized rate of just 2 percent for the six months starting in May.

It's also true that if inflation rises even more, your Series I bond could earn more. No one knows what inflation will do in the future. So look at it this way:

If you buy a Series I bond today, it'll always earn 1 percent above the rate of inflation (because its fixed rate is set at 1 percent). That's not as high as the fixed rate for most older Series I bonds (see "Today's Tip" below), but it's not bad. And that's why I think Series I bonds are a good place to temporarily park at least some of the cash you need for emergencies.

But not all of it. Consider also putting some of the money into such things as CDs. The Federal Reserve has been pushing up interest rates for a while now, and CD rates have also been rising (some faster than others). And don't go by the national averages alone; you can often do better -- sometimes a lot better -- by shopping around at local banks and credit unions.

While you're at it, consider putting at least some of your emergency fund into such things as savings accounts, money-market accounts and money-market mutual funds.

Why? CDs typically carry a penalty for early withdrawal. So do Series I bonds: If you cash in a Series I bond within the first five years you own it, you'll forfeit three months' interest.

Here's another reason: once you buy a Series I bond, you typically must hold it for at least a year before you can cash it in. So it's important to put at least some of your emergency fund in a place you can tap at any time -- without a one-year waiting period.

Following are a few other points to keep in mind:

Series I bonds do not pay out interest. Instead, the interest accumulates, over time. When you cash in your bond, you get back the amount you originally invested, plus all the accumulated interest. (The interest is subject to federal income tax, but is free from any state and local tax.)

Series I bonds are sold at full face value. So if you pay $100, you get a bond with $100 printed on its face, and if you cash it in a year from now, you'll get at least $100 back. (In this sense, Series I bonds are easier to understand than certain other types of savings bonds, which are sold at less than face value.)

It's best to hold a Series I bond for at least five years. If you cash it in beforehand, you'll have to forfeit three months' interest, a penalty that's intended to discourage short-term "traders."

Even though the new, overall rate on Series I bonds won't last forever, 6.73 percent is still pretty darned good, even if it's an annualized rate that lasts for only six months. And remember that the interest, while subject to federal income tax, is free from state and local tax. If you can find a better deal than that for the next six months, let me know.

TODAY'S TIP: Don't cash in those old Series I bonds, because many of them are doing incredibly well. Why? They have higher fixed rates than newer Series I bonds -- some are as high as 3.6 percent, said Steve Meyerhardt, spokesman for the Bureau of the Public Debt in Washington, which runs the nation's savings bond program.

So what happens when you combine that comparatively higher fixed rate on older Series I bonds with the variable rate that reflects inflation? Well, see for yourself:

If you bought an I bond in November 2003, it's now earning interest at an annualized rate of 6.83 percent.

Series I bonds purchased in November 2002 are now earning 7.35 percent.

Series I bonds bought in November 2001 are earning 7.76 percent.

I bonds bought in November 2000 are earning -- get this -- 9.2 percent.

In fact, all Series I bonds purchased since September 1998 (when I bonds were first offered) are earning at least 6.73 percent; some are earning as much as 9.4 percent, or soon will be.

So stick with them.