NS&I Index Linked Bonds and Inflation

WeatherMan

Hi folks,

I am weighing up the options with regard to opening a NS&I Index Linked 3-year bond. It is guaranteed RPI + 1% above inflation and is tax-free.

At the moment the RPI is about 4.9% so the rate would be about 6% - an excellent rate for tax free. My question is what are the drawbacks of this approach? I am happy to tie my money up for a while and also appreciate the security of government backed bonds in the current financial climate.

The main problem i can see is a reduction in Inflation over 3-years. What is the forecast for this? I can see as the economy slows in the next few months inflation may reduce. Also the effect of Oil and Gas price reductions will feed back to a lower inflation. How long will it take to reduce? I'd guess at about 3% by the end of next year? If the economy goes into serious recession does it automtically follow that inflation will reduce dramatically? Prices are still rising in many areas as companies feel the pinch.

Please let us know your thoughts on this.
WM

Milarky

WeatherMan wrote: »

At the moment the RPI is about 4.9% so the rate would be about 6% - an excellent rate for tax free. My question is what are the drawbacks of this approach?

The main problem I can see is a reduction in Inflation over 3-years. What is the forecast for this? I can see as the economy slows in the next few months inflation may reduce. Also the effect of Oil and Gas price reductions will feed back to a lower inflation. How long will it take to reduce? I'd guess at about 3% by the end of next year? If the economy goes into serious recession does it automtically follow that inflation will reduce dramatically? Prices are still rising in many areas as companies feel the pinch.

You've asked the 64 euro question there, haven't you?

With RPI indexing, in general, you know what you are going to get, but not in the same sense as a pensioner. So you will get RPI + 1.01^3 or something like that - a 3 and a bit real return. Of course it is tax free - which is the sweetener - otherwise RPI + 1% is not very good at all given the tie ins.

In general you will do better if

a) the longer the indexation runs,
b) the higher inflation is compared to default assumptions [RPI @ '3%' based on its nominal realtionship with the actual CPI target at 2 and a bit percent.]

eg
@ 3% you get 4% which is 5% to a BR taxpayer or 6.67% to a HR taxpayer
@ 4% you get 5% which is 6.25% (or 8.33%)
@ 5% you get 6% which is 7.5% (or 10%)

If you pay higher rate tax it's a very good deal - comparable to an extra ISA allowance.

Remember that pensioners et al get post facto indexation (so they will be 'compensated' in the next 12 months for a large rise that has already taken place - Sept 2007-Sept 2008) whereas Index Linked Certificates (and 'price-protected' products in general) use the rate of inflation going forward and pay this at the anniversary. Thus you buy a product without knowing what it will provide - apart from the 'real terms' increase, that is.

Inflation may drop away quickly - no one really knows - but look how that has come about - huge asset deflation, leaking into the 'real' economy. In one sense that's a very expensive anti-inflation 'strategy' - that was supposed to be pursued by setting interest rates instead.

isofa

I don't think anyone can really answer your question of where inflation will go, if they could they'd be betting on it!

Note - you can withdraw after the 1st year too, so as long as you leave the money in for at least a year you'll benefit from the index linked interest.

Have a read of this thread, which discusses the product in detail.

opinions4u

While the BofE is tasked with getting inflation down, I would expect to see RPI drop a little after Xmas.

Wolf_Man

Thanks Milarky.

A very useful analysis.

WeatherMan

Thanks for the considered and detailed responses.

It seems to be not a bad product, especially as one can escape after a year if the assessment of inflation at that time is lowering. The tax-free status of this account make it viable (likely equivalent of 6.25+% gross in normal savings account in first year before basic tax), not top of the charts but good for the 100% safety it provides in these turbulent times.

Thanks again,
WM

ozzage

Hello - first post here, quite new to the UK, and just wanted to clarify something on this topic.

I'm a HR tax payer so these look like an interesting option if I decide that I'm happy to keep some money tied up. I already have a maxxed out Cash ISA.

The very useful post above from Milarky shows the following:

@ 3% you get 4% which is 5% to a BR taxpayer or 6.67% to a HR taxpayer
@ 4% you get 5% which is 6.25% (or 8.33%)
@ 5% you get 6% which is 7.5% (or 10%)

On the NS&I website it states:

Tax-free rate pa/AER : Index-linking + 1.00%
Equivalent gross rates : Index-linking + 1.25% basic rate, 1.67% higher rate

Given that the RPI is now 4.8%, doesn't this suggest that the equivalent gross rate for a HR taxpayer is 4.8 + 1.67 = 6.47%? How can that be right? What have I missed, or rather what do they mean by this since it's obviously not what I thought?

Looking at the "@5% you get 6% which is 7.5% (or 10%)" obviously I'm not comparing apples with apples here.

Could somebody please clarify these two figures and how they relate to each other? If I'm trying to compare directly to a savings account AER, which figure should I use?

Thanks for the help, and for the site. It's invaluable for working out all the available options in a relatively painless way when new to the country!

Count_Dante

As I understand it, 1.25% charged at basic rate = 1% and 1.67% charged at higher rate = 1%. But the amount you get is RPI + 1%, regardless of your tax status. What you thought originally is correct.

The savings are excellent even for basic rate taxpayers. Remember, you are not just getting a good deal on the interest rate, but you are getting what amounts to an insurance policy against stupid inflation. Inflation is predicted to drop, but you just don't know.

ozzage

Thanks Count for the response, but to be honest I'm still confused!

Where did the (approx.) 10% figure in Milarky's post come from?

chris1

Don't forget, you don't actually know what you'll be getting until a year's time - you'll get the fixed percentage plus whatever inflation is then, and again on the next anniversary and so on.

For example it doesn't matter what inflation is now, or in six months, if it's 2% in a year's time, that's what you'll get.

Milarky

ozzage wrote: »

I'm a HR tax payer so these look like an interesting option if I decide that I'm happy to keep some money tied up. I already have a maxxed out Cash ISA.

On the NS&I website it states:

Tax-free rate pa/AER : Index-linking + 1.00%
Equivalent gross rates : Index-linking + 1.25% basic rate, 1.67% higher rate

Given that the RPI is now 4.8%, doesn't this suggest that the equivalent gross rate for a HR taxpayer is 4.8 + 1.67 = 6.47%? How can that be right? What have I missed, or rather what do they mean by this since it's obviously not what I thought?

Looking at the "@5% you get 6% which is 7.5% (or 10%)" obviously I'm not comparing apples with apples here.

Could somebody please clarify these two figures and how they relate to each other? If I'm trying to compare directly to a savings account AER, which figure should I use?

From another page at NS&I:

Because all the returns are yours to keep, the equivalent gross return is higher. To match a tax-free return of, say, 4% a year, a basic rate taxpayer would need to earn 5% before tax. And the same tax-free return would be worth 6.67% if you pay tax at the higher rate (based on current tax rates). So you can see the advantages of investing tax-free.(http://www.nsandi.com/products/ilsc/howitworks.jsp)

I thought that quote you gave looked strange. What they should have said there was something like:

Tax-free rate pa/AER : Index-linking x 1.00 + 1.00%
Equivalent gross rates : Index-linking x 1.25 + 1.25% basic rate; Index-linking x 1.67 + 1.67% higher rate