Why You Should Be Wary Of Fixed Rate Bonds

Savers are being urged to take out fixed rate bonds before returns drop, but here's why you should think twice before you lock your money away.

If you're happy to lock your money away for a while, you could still earn a top rate of 7% or more with a fixed rate bond. Bonds have become popular with savers who are after the best possible rates to counter the effects of high inflation.

In fact, you may have read articles in the press recently which encourage you to take out bonds quickly before the attractive returns disappear for good.

But I would be cautious of this `hurry while stocks last' approach. Just a few weeks ago I was more upbeat on bonds in my article: Is It Safe To Lock Your Savings Away? But since then, the global financial crisis has worsened and my former optimism is fading.

In theory, I'm still keen on the way fixed rate bonds work. In return for locking your money away, fixed bonds normally provide better returns than instant access savings accounts. And with a fixed rate you'll know exactly how much you'll get back at the end of the term, unlike variable rate accounts.

Of course, there's always a risk your fixed rate may become uncompetitive if savings rates in general increase. But at a time when cuts in the Bank of England's base rate look likely -- which will probably be followed by a series of reductions in savings rates -- bonds look more attractive than ever.

But I would urge you to think twice before making the decision to tie your money up. Here's why:

Compensation

If a bank -- which is covered by the UK's Financial Services Compensation Scheme (FSCS) -- goes bust, you'll be entitled to maximum compensation of £50,000 from your bond. (That's assuming you don't have any other savings with the bank or any other bank listed under the same banking licence.) Remember compensation covers both the original capital deposited in the bond and interest earned up to the £50,000 limit.

In other words, bond savers have exactly the same rights to compensation under the FSCS as they would for savings in an easy access account.

So, what's my problem? Well, it's the length of time it could take to resolve compensation claims which concerns me.

This is how compensation works for bonds:

Once the bank has gone into default, the FSCS will take over your bond until the end of the term. If no access is allowed from the bond, then you won't be able to claim for compensation until it has matured.

Imagine you take out a two-year bond without access, but the bank goes bust after six months. You would have to wait another 18 months before you can even ask the FSCS for compensation. And who knows how long it could take after that before you see a penny.

Although I think it's fair for the bond to continue under the same contract once it has been passed to the FSCS as it would have done with your bank, I'm not keen on the prospect of money being stuck in limbo for months on end.  

That said the timescale for claiming compensation is shorter if your bond allows some access. Let's say you have a bond which accepts withdrawals after 30 day's notice. In this case, you'll be able to claim for compensation once 30 days has passed without having to wait until the bond matures.

I'm also a little concerned about the market leader, ICICI Bank UK. The Indian bank pays a high rate of 7.10% on its HiSave Fixed Rate Bond (without early access).

ICICI has a high Credit Default Swap of around 1300 basis points which is much higher than for most banks. That means the market is worried about the bank and thinks there's an approximate 13% chance it will go bust. (Read more about CDS spreads here.)

Of course, the market may be wrong. ICICI is crucial to the Indian economy so there's a strong chance that the Indian government wouldn't let it go bust. Indeed, in September, the FT reported that the Reserve Bank of India had already stepped in to prevent a run on the bank following a loss of confidence.

What's more, ICICI's UK subsidiary is fully covered by the FSCS and savers have exactly the same compensation rights as they do for any bond held with a UK bank. But I remain a little nervous which is why I'm steering clear of fixed rate bonds.

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