The bond guaranteed to beat inflation

National Counties building society has filled the gap left by National Savings with a five-year bond guaranteed to beat inflation.

A lifeline for savers

At a time when inflation remains stubbornly high and the government has withdrawn the only inflation proof investment, index-linked National Savings Securities, it is heartening to see one institution offering a lifeline to savers.

The small National Counties building society is offering a five-year tax free ISA (individual savings account) investment which will pay 1% above the rate of inflation, as measured by the retail prices index (RPI). The only drawback is that savers must be prepared to lock up their money for the full five years as no withdrawals are allowed during the term of the bond.

The minimum investment is high at £5,100, the maximum annual amount allowed for a cash ISA. National Counties will also accept transfers from other companies so someone who has put the maximum into a cash ISA every year since their introduction will be able to inflation proof around £50,000.

FSA gets tough

The gamble, of course, is that nobody knows what inflation might do over the coming five years. Were RPI to remain at its latest rate of 4.8% until 2015, National Counties’ ISA would give savers an annual return of 5.8% a year.

However, the government and the Bank of England would consider inflation at this level a big failure and there would be pressure to bring inflation down to its target level of 2% for the consumer price index (CPI).

The Financial Services Authority has got tough with National Counties over the figures it was using to promote the index-linked bond and is insisting that it uses the average RPI over the last five years as an 'illustrative rate of 3.96%. Initially, the society quoted potential returns of 5.82% a year in its marketing material.

Halifax next best bet

Savers must consider whether the National Counties' inflation-linked deal, with its unknown return, will turn out to be a better bet than the best fixed rate ISA from Halifax, which is currently 4.25% for four years with a much lower minimum investment of £500.

Economists are divided on the longer term outlook for inflation. In the short term RPI is likely to stay comparatively high because of rising food and fuel costs and the introduction of VAT at 20% in January of next year. In its quarterly inflation report last week, the Bank of England warned that CPI – which has generally risen at a lower rate than RPI – was likely to remain above its 2% target rate into 2012, falling thereafter (see chart).

Latest figures from the Office for National Statistics show that the annual rate of inflation as measured by CPI slowed to 3.1% from 3.2% in June while the RPI dropped from 5% to 4.8%. The CPI figure was the lowest since February but the eighth consecutive month that it has exceeded the Bank's 2% target. 

For those who think deflation (falling prices) is more of a problem in the longer term, if the RPI falls over the five-year term, investors in the National Counties bond will receive their capital back in full plus 1% interest a year. 

No safe investments

The new bond will be welcomed by savers as National Savings Index Linked Savings Certificates were withdrawn last month and there is now no investment, suitable for small investors, guaranteed to beat inflation. Most taxed investments cannot even keep pace with inflation and the institutions are taking advantage of the ‘tax free’ label on ISAs to pay very poor rates of return.