Calling all fixed rate bond holders – time to face the truth
The troubles facing fixed rate savers have been commented on frequently in recent months as the harsh reality of maturing bondholders facing significant drops in income levels continues to have a dramatic impact on so many of us. But more and more savers still need to face the real truth about the impact this is having and understand the viable options available. Here, we take a look at this genuine savings dilemma as well as one particular option that could be a middle ground for those looking to improve the poor fixed rate returns available from their capital.
The need for interest
The need for a competitive return from our capital is never more prominent than when we consider the level of interest available from fixed rate savings. Whether you need the interest to help boost income, or simply use the interest to help grow your capital, either way you are facing a period of record low returns on offer.
The need for income is also one of the most consistent demands put on our capital, whether you are working and need to supplement your earnings, or retired and looking to add to your pension income, but unfortunately the current economic environment is proving to be one of the most challenging ever seen. With record low interest rates looking here to stay and the ever-increasing impact of above target inflation, these demands on our capital have never been greater.
Fixed rates failing to deliver
While the continuation of record low interest rates is great news for businesses and individuals who are borrowing, it brings no joy to savers. Recent research from HSBC (source: Daily Telegraph) shows that almost 5.3 million fixed rate products worth nearly £93 billion will mature in 2013. Most worrying is that with around 500,000 maturing every month for the rest of the year, the prolonged reduction in savings rates means that bondholders are faced with a serious dilemma.
With leading 1 year fixed rate bonds offering around 2%, three year fixed rates paying only around 2.55% and 5 years offering 3.15%, the result is that millions of savers who have fixed rate bonds maturing are facing significant drops in the level of interest available from similar products, many falling by as much as 50%.
Inflation deals a double blow
Even with the headline rate of inflation, the Consumer Price Index, remaining at 2.7% in September, inflation is still a major concern for fixed rate savers. At this level, all but non-taxpayers require an annual rate of 3.4% just to stand still. Based on current leading fixed rates outlined above, this means that even if you are prepared to commit your capital for longer, you will not be able to provide a hedge against inflation, meaning you are losing money in real terms.
Although based on fixed rate bonds currently available 3% fixed per annum may seem like a top deal, but with inflation currently running at 2.7% you are only making 0.3% each year and if you are at least a basic rate tax payer, you are losing money in real terms with a negative return of -0.3% net each year.
Risk warning for savers
Also remember that if you do tie yourself in now and inflation goes up by only a small amount during your fixed term, your real return (i.e. the return after inflation and tax) could erode even more quickly, and the longer you fix for the more pronounced the impact could be. This indeed is a serious situation that demands our full attention.
Perhaps the risk warning that should be made by every provider before a customer buys a fixed rate bond is to make it quite clear that you will lose money in real terms unless inflation falls sharply and remains at a much lower level. The impact of inflation, especially over time, is something which not enough savers put sufficiently high on their priority list prior to taking action.
Time to face the truth
This combination of continued low savings rates and above target inflation is resulting in more and more watching the spending power of their savings diminish and demands both savers and investors to keep an open mind regarding their options.
Standing still for too long or losing sight of the real impact of inflation can produce painful results and so now is the time to face this truth and make sure your capital is working for you, not against you. The reality though is this leads to savers being faced with the toughest of decisions, either lose money in real terms from a savings account, or take on more risk.
Go short term
Understanding the real implication of low fixed rate bond rates, maximising Cash-ISA allowances and giving full consideration to alternatives available in the market are all good places to start.
Faced with a fall in income of up to 50%, one option being considered by savers is to look to shorter term accounts. However, leading instant access accounts are only paying around 1.6% and unfortunately this is where much of the fixed rate bond maturities seem to be ending up. If this is the case, then the reality is a harsh one. Based on the current rate of inflation, basic rate taxpayers are losing around 1.4% a year.
Diversifying savings portfolios to have a variety of products could help ensure that you lessen the impact of low interest rates. The combination of a wider range of options could also offer a more stable way to provide the level of returns savers have previously enjoyed and need over the longer term.
For those prepared to put their capital at risk in order to provide a higher fixed income the Enhanced Income Plan from Investec offers 6.12% fixed each year, paid to you regardless of the performance of the stock market. This is paid in monthly instalments of 0.51%.
The trade off for a fixed income which is well over double the rate of inflation as well as the highest return available from fixed rate bonds is that your capital is at risk. This investment contains what is known as conditional capital protection which means that your initial investment will be returned in full unless the FTSE 100 Index falls by more than 50% during the investment term. If it does, and the Index also finishes below its starting level then your original capital will be reduced by 1% for each 1% fall. Therefore, this plan should only be considered if you are prepared to lose some or all of your capital.
Take the situation where £20,000 matures from a 3 year fixed rate bond. If this bond was paying 4% and leading rates are only paying 2.55%, this is a reduction from £800 each year to £510, a difference of £290, equivalent to a reduction of over a third.
In order to match the original level of £800 income, £8,100 would need to be invested in the fixed income investment, with the remaining £11,900 in the three year fixed rate. The additional risk involved by taking this route is that the £8,100 allocated towards the investment is at risk. In addition, the investment has a six year term rather than three and so you are committing your capital for longer.
Cash ISA transfer option
With interest rates likely to remain low for quite some time, there has also been an increasing trend of savers transferring their Cash ISAs to Investment ISAs in an attempt to try and counter the challenges they face by giving up the security of cash for potentially better returns.
Transferring your Cash ISA can be done without the loss of your ISA wrapper and it will not affect your annual ISA allowance for the current tax year. However, if you are considering this option you should be aware that Cash ISAs and Investment ISAs are very different and that Investment ISAs such as the Investec Enhanced Income Plan do put your capital at risk. Also note that once you have transferred to an Investment ISA you cannot transfer back to a Cash ISA.
Fair Investment conclusion
Commenting on the investment, head of savings and investments at Fair Investment Company, Oliver Roylance-Smith, said: “The high level of fixed income and the monthly payment frequency are attractive features of the Investec Enhanced Income Plan and with savings rates continuing at historically low levels there is sizeable pressure mounting on savers to seriously consider what is the best home for their money.”
He continued: “Unlike savings plans, investing puts your capital at risk and so you should only consider this investment is you are prepared to lose some or all of your initial capital. However, should you consider the need to move some of your capital into investments or are considering additional investments or ISA transfers, this plan could be a compelling opportunity to provide a competitive level of fixed income while offering your initial capital some protection against a falling market”.
No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular plan. If you are at all unsure of the suitability of a particular product, both in respect of its objectives and its risk profile, you should seek professional advice.
The Investec Enhanced Income Plan is a structured investment plan that is not capital protected and there may be the risk of losing some or all of your initial investment. There is also a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated, in which case you may not be entitled to compensation from the Financial Services Compensation Scheme (FSCS). In addition, you may not get back the full amount invested if the plan is not held for the full term. The past performance of the FTSE 100 Index is not a guide to its future performance.