Hooray! Inflation-linked bonds are back

With inflation as measured by the retail prices index predicted to hit 5% or even 6% within the next year or so, the new launch of index-linked National Savings Certificates is bound to create a lot of interest.

There is no other investment which guarantees an annual return of RPI inflation plus 0.5% tax free over the coming five years, so the return of inflation proof bonds after 10 months absence will be welcomed by many. 

Slightly less attractive

The deal is not as generous as the previous issue which had a return of RPI plus 1% and there was the option of a three or five-year bond. The new issue is for five years only. ‘Our aim is to keep savings certificates on sale for a sustained period of time and to enable as many savers as possible who wish to invest to do so,’ said Jane Platt, chief executive of National Savings & Investments.

‘With this in mind we will be offering a five-year term, only available direct from NS&I. ‘We understand fully that we will see very high demand for index-linked savings certificates. For those who want to invest the easiest and quickest way is to visit nsandi.com.’ Minimum investment is £100 and the maximum per person is £15,000. 

The return on the new issue of NS&I’s index-linked certificates is tax free and investors can expect their investment to be worth probably around 5.5% more after the first year. This is equivalent to a gross return of 6.87% to a basic rate taxpayer, and a whopping 9.16% to a 40% taxpayer or 11% to a 50% top rate taxpayer. The top rate five-year fixed interest deposit account from Birmingham Midshires pays 5.05% gross – well below the expected first-year return from the NS&I Inflation Linked product.  

Outlook for RPI inflation

So will inflation at around 5% continue for the coming five years? And what if interest rates rise to curb inflation and the return on fixed rate deposit bonds improves? Commenting on the Bank of England’s recent inflation report Bryn Jones, fixed income specialist at fund manager Rathbones, said: ‘CPI may well hit 5% this year and RPI is going to hit 6%, and I think it could remain well ahead of the 2% target next year as well. However, no firm indication from the Bank of England about an interest rate rise has been offered. This continues to leave the expectation of an interest rate rise in the balance.’

Ted Scott, director, global strategy at investment group F&C, believes the details of the Bank of England three-monthly inflation report were an implicit admission that stagflation (rising inflation combined with low growth) is the prospect that faces the UK economy. ‘In the report, the Bank once again raised its inflation forecasts and now believes it will peak at around 5% (CPI) in the fourth quarter of 2011, up from 4.5% in the third quarter in the last inflation report in February.’

‘Furthermore, the longer-term forecasts have also been increased so that now CPI is not expected to return to the Bank's 2% target until the second quarter of 2013,’ said Scott. In his inflation report the governor of the Bank of England, Mervyn King said he thinks inflation will fall to 1.9% in two years. But the Bank of England has been consistently wrong in both its inflation predictions and its growth forecasts. In order to curb inflation King said it will be necessary to start raising interest rates sometime soon - but didn’t say when. 

Low penalties for opting out

So the gamble for investors in the NS&I certificates is whether RPI plus 0.5% tax free will continue to be a better return than can be achieved elsewhere. There is a chance to change your mind however, with very little loss. If you cash in the investment during the first year you will receive a return of your original investment. You probably wouldn’t want to do this anyway with RPI inflation running at 5% or more. But after the first year, on early encashment you receive index linking for however many months you have held the bond, plus a proportion of the 0.5% bonus. 

In year two the amount credited on top of inflation is 0.35%, 0.4% in year three, 0.65% in year four and 0.86% in year five to equate with the average 0.5% added each year if you hold the bond to full term. Given that most of the return will be in the index-linking, this is a relatively small penalty to pay for opting out if something better comes along.

Not available at the Post Office

Savers can invest in savings certificates on www.nsandi.com, via NS&I's UK-based contact centres or by post. They will not be available through the Post Office. Demand is likely to be strong so don’t delay if you decide that it is worth a gamble on inflation as the issue could be withrawn without notice. The last, more generous, issue was withdrawn in July of last year due to ‘exceptional demand.’  The certificates come with a 100% guarantee of return of capital.

Other index-linked bonds

So how do the NS&I Index Linked certificates compare with BMSavings Index Linked bonds? BMSavings is offering RPI link plus 1.5% for a five-year investment or RPI plus 0.75% for a three-year investment with a minimum of £500. The returns are taxable so clearly won’t be as good as NS&I’s bonds – unless you are a non-taxpayer in which case the return is better. Sadly the bonds cannot be held in an ISA.