Question: 
What are your thoughts on buying Ibonds instead of bond mutual funds?

Answer:
Ibonds are an inflation-adjusted type of U.S. savings bond, and the interest they pay consists of two parts, a guaranteed rate that is fixed when the bond is issued and is good for up to 30 years, plus a variable rate that changes every six months and is identical to the percentage change in the Consumer Price Index for urban consumers.

Both the fixed rates on new bonds and the variable rates that apply to all bonds are subject to change twice a year, on May 1 and November 1.

Ibonds on sale from now through April 30, 2001 have a guaranteed fixed rate of 3.4 percent. (It was 3.6 percent during the previous six months.) Until April 30, the variable rate on all Ibonds is stated as 1.52 percent, a six-month rate that would be equivalent to 3.06 percent if it continued for a year. Therefore the current Ibond rate is equivalent to 6.46 percent.

These bonds are targeted at long-term investors and come with a guarantee of principal plus all interest as it is earned. They are available in denominations from $50 to $10,000, and you can buy up to $30,000 of them per calendar year.

Six months after they are issued, they can be cashed at any time; but there's a penalty of three months' interest if they are cashed within five years from the time they're issued. One way to minimize the penalties is to buy several bonds in smaller denominations instead of one bond in a larger amount.

For instance, if you have $5,000 to invest, you could buy a single bond for $5,000, 10 bonds for $500 each or 50 bonds for $100 each. You'd get the same amount of interest from any of those combinations. But if you later need to cash in only part of the money, you'll appreciate being able to sell enough bonds to meet your needs without having to cash in the whole $5,000.

All interest on the bonds is free of state and local income taxes, and federal income tax is deferred until they are cashed. This means there's no point to own them within an IRA unless it's a Roth IRA. But a better use of Ibonds is to increase your tax-deferred savings once you have maxed the contributions you can make to an IRA or a 401(k).

In sum, an Ibond seems a bit like a government-backed, variable-rate, tax-deferred certificate of deposit. That's a nice combination for risk-averse investors.

Ibonds have another feature that can make them quite attractive to some investors: There's no tax on the interest if they are cashed to pay for qualified higher education expenses. If a parent or grandparent buys a $10,000 Ibond for a newborn child (assuming interest of 6.46 percent), the bond can be cashed for about $31,000 at the child's 18th birthday - a great tax-free start on a college education.

Ibonds, in other words, offer a variable and guaranteed income with no risk of losing principal and a tax-deferral thrown in. Their yield seems to be relatively competitive. Vanguard's venerable Total Bond Market Index Fund has a current yield of 6.61 percent, for example, but that interest is taxable when it's distributed to shareholders.

Perhaps the biggest difference between the Ibond and a bond fund is what happens if interest rates go up or down.

If rates go up, the interest on Ibonds will follow, paying a higher yield. The principal (and all accumulated interest) will not be affected. A bond fund, on the other hand, will lose some of its share value because bond prices almost always change in the opposite direction of interest rates. But the bond fund's interest will gradually increase.

If rates go down, the interest on Ibonds will also fall, but neither the principal nor accumulated interest will follow. But a bond fund will gain in share value while its yield gradually drops.

In the end, this question comes down to "different strokes for different folks." Ibonds are a dynamite way to get tax-deferred interest. But bond funds have more flexibility, plus the chance for capital appreciation if interest rates fall.

For more information on Ibonds, visit www.publicdebt.treas.gov/sav/sav.htm