Beware investing in inflation-linked bonds

Published by Sylvia Morris on 21 June 2011.
Last updated on 20 July 2011

National Savings and Investments has reintroduced its index-linked savings certificates paying inflation plus 0.5% a year for five years.

The news came just 24 hours after the governor of the Bank of England gave a heavy hint that the rise in inflation - which the Bank said could hit 5% in the final months of the year - has tilted the balance of opinion towards an early increase in interest rates.

Inflation of 5% - as measured by the government's preferred Consumer Prices Index - would be double the government's target. Just three months ago, the Bank said inflation would only hit 4.5% this year.


NS&I withdrew its index-linked savings certificates in July last year. Ever since, banks and building societies have been filling the gap in the savings market by offering bonds where your return is linked to inflation. But these bonds have been described as "complicated" compared with the NS&I product.

Their launch comes at a time when the cost of living as measured by the RPI is already running at 5%. The top rate you can earn on an easy-access account is 3.35% before tax, while the top five-year bond pays 4.65%.

The new deposit accounts from banks and building societies pay the equivalent of the rise in the RPI over three or five years plus a little bit extra. If inflation falls during the term you will get your money back, plus the small amount of interest on top.

But while they seek to mirror the NS&I version, they are not as simple as they might first appear. Savers need to study the terms and conditions carefully before signing up.

Watch out for tax

Some accounts are taxable - so you can find that your money will not keep pace with inflation once you have paid tax.

Others you can wrap in an ISA, so the returns are tax-free. You have to tie your money up for three or five years and can't make any withdrawals during that time. If you want your money back early, you could also face a charge.

At data analyst Defaqto, banking expert Kevin Bray says: "These accounts are complicated. They may look attractive now in the light of high inflation, but might not be so in the longer term. You also need to look at when the RPI is calculated. If inflation falls sharply and you fall into the wrong month, you could lose out."

They are made all the more complicated as banks and building societies offer different "issues" of the accounts with different interest rates and start dates. And you can find that the bond will not start running for weeks after you hand over your money, meaning that you earn a pittance before the start of index linking.

For example, with the Yorkshire Building Society Protected Capital Account Inflation Linked 4 plan, you can hand over your money now, but the bond does not start running until 29 June, so your money will be tied up until then. And during that time it pays RPI plus just 0.29% a year. Your interest is linked to the RPI April figure, announced in May each year.

Future uncertain

These bonds generally roll up for savings and interest over the term. But BM Savings pays the interest out each year. You cannot have the taxable income added to your account. Yet this is one of the most generous schemes on the market, paying 1.5% a year before tax - worth 1.2% to basic-rate payers - on top of inflation. 

Of course, how well you will actually do with these bonds depends on the future course of inflation. The rise in the cost of living may be set to increase in the near term, but experts expect it to fall back sharply within a year.

The Centre for Economic and Business Research forecasts the RPI down at 3.3% in the first quarter of next year and to average 2.7% between 2012 and 2015.

Scott Corfe, economist at CEBR, says: "We expect inflation will start to fall as the pressures of rising commodity prices recede. The weak economy puts constraints on price growth. And the rise in VAT, which came into effect at the start of this year, will fall out of the index next January. We expect a significant fall in inflation by the start of next year."

If this happens then the return of your index-linked bond will also fall. 

The BM Savings bond will pay 6.5% a year before tax with inflation running at 5%. After tax, this is worth 5.2% to basic-rate taxpayers - marginally ahead of inflation. But for higher-rate taxpayers, the return after tax is 3.9% - less than the inflation rate.

When interest rates rise...

If inflation averages 3% over the next five years, your return will drop to an average 4.5% a year before tax. But BM Savings currently offers a five-year fixed-rate bond paying 5.05% before tax.

And as interest rates can surely only go one way - upwards from their historic 0.5% low - you could do better by sticking to a shorter fixed-rate bond and then picking up higher rates in a year or two's time if they materialise.

Another option is to stick to top-paying easy access accounts, such as ING Direct's Direct Savings account.  You will then be ready to make the most of better savings rates when interest rates do rise.

Questions to ask

1: What will I earn a year on top of inflation and is it taxable?
2: Who is the deposit taker and will I breach my £85,000 limit under the Financial Services Compensation Scheme?
3: Does the interest roll up or is it paid out each year?
4: When does the term start and how much interest do I earn between handing over my money and the start of the bond?
5: Which month's annual rise in the RPI counts?
6: Will I lose some of my capital if I cash in my bond in early?

This article was taken from the June 2011 issue of Money Observer.

More About

Leave a comment