New inflation-linked bond to rival NS&I

The Post Office have just released an inflation-linked bond that pays 1% more in fixed interest than the popular NS&I Savings Certificates...

They used to be best of friends. In fact, barely a year ago you could even stroll into the branch of one, and pick up an account issued by the other. But, no more – the Post Office and National Savings and Investments (NS&I) are now rivals, battling it out in the arena of inflation-linked bonds.

NS&I returned to the inflation-linked market last month with the 48th issue of their popular Savings Certificate paying 0.5% over the Retail Prices Index measure of inflation (RPI). But in the ten months that NS&I had been absent from the sector, several other linked accounts began to appear. One provider who launched such an account was the Post Office, offering a bond paying 1.5% above RPI.

The first issue of this Post Office account was taken off sale back in April, around a month before NS&I returned to the market. But now a second issue has been released – pitting the Post Office in direct competition with its former partner, NS&I.

Earn a possible 6.7%

The Post Office is offering the second issue of their Inflation Linked Bond on a three-year and five-year term. The three-year bond pays 0.5% over RPI while the five-year account is priced at 1.5% over RPI. There is a minimum initial investment of £500 (and a maximum of £1m) and no additional withdrawals or deposits are allowed throughout the fixed term.

Both bonds begin on 10 October 2011 and the interest rate is calculated yearly using the August RPI reading published by the Office for National Statistics every September. So if RPI is still at 5.2% come August 2012, you’ll earn 6.7% on your nest-egg in the first year of the bond’s life. The interest for each year is then paid in one lump sum at the end of the term according to the yearly readings.

If an RPI reading of 0% is recorded, or the country goes into deflation (a negative RPI reading), then a set rate of 0.5% for the three year bond and 1.5% for the five year bond will be paid.

Here’s a table showing how the yearly interest rates would be calculated on the five-year bond in relation to changing RPI readings...

However if you are a taxpayer, you will have to pay income tax on the interest payments – bringing the real-return down considerably. If you pay at basic rate, you will still be able to beat inflation and tax using the five-year bond, so long as RPI does not climb past 6%. But if inflation moves beyond this level, the tax payable on your savings will bring your real interest rate back below RPI – and you will lose money to rising prices.

If you go for the three-year bond, you’ll only be able to beat inflation after basic rate tax has been deducted if the RPI drops below 2%. An unlikely occurrence in the current financial climate!

Indeed, when it comes to tax, the Post Office Bond can’t really compete with NS&I...

NS&I’s secret weapon

The NS&I five-year Savings Certificates may only pay 0.5% over RPI – but it is paid tax-free. This means that no matter what level RPI is at, you will always beat inflation. In fact, as long as RPI stays above 3.5%, you’ll also beat the five-year Post Office Bond on price!

Unusually, NS&I also let you make withdrawals or cash in the whole Savings Certificate before the end of the five-year term. However if you do take money out in the first year of the bond's life, you will earn no interest on the first year of your investment.

This generous loophole from NS&I also means that stashing your nest-egg away in a Savings Certificate and withdrawing it after its third anniversary will always provide a higher overall interest rate than the three-year Post Office Bond pays after basic rate tax.

But beware – if you do withdraw your savings before the full five-year term of the certificate has runs its course you won’t earn 0.5% over RPI. This is because the annual interest rates on the Savings Certificates are staggered and increase year on year. Here’s how they stack up...

Savings Certificates also allow you to make additional deposits, as long as the issue is still available and you do not exceed the £15,000 maximum investment. And what’s more, as NS&I is government backed, your savings couldn’t be in a safer place – even in the current economic state!

But there are a few drawbacks to inflation-linked bonds...

Relying on inflation

Inflation-linked bonds are great if your only concern is to stash away your cash away and protect it from rising prices. But if you’re more concerned with always getting the highest interest rate on your nest-egg a linked account may eventually backfire on you.

It goes without saying that inflation-linked bonds only offer a high return if RPI is running at a hefty level – as it is now. But when inflation falls, as it eventually will (especially if the base rate is upped), you may find yourself stuck with a very uncompetitive interest rate.

This is less of a problem with the NS&I Certificates, as you are able to withdraw your cash at any point. But if you lock into a Post Office bond, you could be kicking yourself in two years if RPI has plummeted and you are unable to switch to a better account.

So with that in mind, here are some shorter term and easy access fixed rate savings account for those of you who don’t fancy an inflation linked bond...

Which do you prefer?

The Post Office Bond, NS&I Savings Certificate or a regular Fixed Term Account?

Let us know in the comment box below.

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