What to do now you can’t buy National Savings certificates

Cautious investors looking to put their money into National Savings certificates have suffered a big setback; National Savings & Investments has withdrawn all its index-linked and fixed interest Savings Certificates from sale.

The Government sets a target for how much money the state-owned lender can issue as certificates to avoid ‘crowding out’ the private sector. After all, the 100% security that NS&I offers due to its Government-backing is impossible for High Street banks to compete with.

According to NS&I, its fixed term, tax-free savings certificates had become too popular, and demand was outstripping the permitted supply.

The official press release on the certificate withdrawal states:

NS&I today announced that its Savings Certificates (both Fixed Interest Savings Certificates and Index–linked Savings Certificates, also known as Inflation-Beating Savings) have been withdrawn from general sale and that it is reducing the interest rates paid on its Direct Saver and Income Bonds by 0.25% with immediate effect.

Sales volumes in recent months across all three products have far exceeded those either anticipated or required by NS&I.

Jane Platt, Chief Executive, NS&I, said: “NS&I has a unique position at the heart of the UK savings sector and we continue to follow a policy of acting transparently and balancing the interests of our savers, the taxpayer and the stability of the wider financial services market.

“While doing this we are tasked with meeting the government financing objective – called our Net Financing target – which is set for us each year by HM Treasury. This year we have agreed to broadly balance the funds coming into NS&I with the funds leaving us – in other words our Net Financing target is zero within a range of £2.0 billion either side of this.

“We’ve seen significant amounts of money invested into these products over recent months and so we’ve taken the difficult decision to withdraw Savings Certificates from general sale and reduce the interest rates paid on our Direct Saver and Income Bonds. This is designed to ensure that we do not exceed the upper end of our Net Financing target range.”

What does it mean for your portfolio?

There’s been a bit of panic about NS&I’s move. Some conspiracy theorists even claim the Government believes RPI inflation will remain above target, and that it’s withdrawing the inflation-linked certificates to avoid paying high interest rates in years to come.

That seems unlikely, since it withdrew the fixed interest certificates, too. If the conspiracy theorists were right, it’d have kept issuing fixed rate certificates, as the fixed annual coupon would be whittled away by inflation.

I believe the official reason given in the press release; last December NS&I withdrew its fixed rate savings bonds from the market for a similar reason. In the wake of bank runs, the credit crisis, and the on-going fear of investing in the stock market, it seems the allure of rock solid Government-backed saving has proved just too popular.

That said, I’ve no doubt the switch to CPI-targeting by the Government has also made the Index Linked certificates look anomalous, if not dangerously expensive, as The Telegraph’s Ian Cowie wrote yesterday:

Earlier this month, after the Government announced it was switching most pensions’ indexation from RPI to CPI, I asked in this space: “How long will it be before the Government decides it also prefers to use the lower measure of inflation as the benchmark for National Savings & Investments‘ index-linked certificates? Or index-linked gilt-edged stock? Both are currently linked to RPI but, when politicians start helping themselves to savers’ private property, it often proves habit-forming.”

Now it has found a different and more drastic way to cut the cost of NS&I index-linked certificates – and the Debt Management Office says it is looking at issuing gilts issued to CPI. Last year – and again in January, 2010 – I reported that the Bank of England had switched 70 per cent of its staff pension fund into index-linked gilts and commented that this was as close as you can get to officially-sanctioned insider-trading. The annual rate of change in RPI has doubled since January and I tipped NS&I index-linked certificates again in this space in May.

Cutting off the supply of Index Linked certificates kicks the ball down the road for a while. When they return, they’ll surely be CPI-linked.

Life after National Savings certificates

The big question is what should you do if you’d planned to invest money via these certificates?

The inflation-linked certificates in particular were a very attractive way for UK investors to diversify a portion of their portfolios into a super safe inflation-protected vehicle.

The tax-free nature of the certificates also made asset allocation easier for higher rate private investors looking for a fixed income.

Unfortunately, there’s nothing else available that’s directly comparable to the Index Linked certificates, though I’ll discuss the closest thing – Index Linked gilts – below.

There are however plenty of alternatives to the fixed income certificates that will achieve the same sorts of ends, although none offer exactly what the certificates offered.

Let’s quickly look at each in turn.

If you’ve already got certificates: rollover

NS&I says existing National Savings certificate holders can rollover their maturing certificates:

On maturity, existing Savings Certificate customers can continue to rollover their investment into the same Issue they currently hold. They can also reinvest into any of the Savings Certificate terms and Issues – either the 3 or 5 year Issue of Index-linked Savings Certificates or the 2 or 5 year Issue of Fixed Interest Savings Certificates – regardless of which Savings Certificate they currently hold. However, as Savings Certificates have been withdrawn from general sale, customers who have invested in other NS&I products will not be able to reinvest their money into Savings Certificates.

If I were a holder I’d be inclined to do that, all other things being equal.

Otherwise, once you move your money out of the certificates, you won’t be able to put it back in until the products go back on sale.

While we’ll no doubt see new issues one day, we’ve no idea exactly when.

Cash ISAs

The fixed rate National Savings certificates NS&I has withdrawn only offered a low rate of interest, but there was no tax to pay on the money you received.

This made their after-tax income comparable to the higher-paying ‘savings bonds’ of High Street banks, especially for higher rate taxpayers whose income from interest is taxed at 40%.

However, the best fixed rate cash ISAs offer better interest than the fixed income certificates did, and are tax-free too.

If you can lock your money up for two years then you can currently get 3% from the Barnsley Building Society, while Halifax has an easy access cash ISA paying 2.6%.

Fixed interest savings bonds

If you’ve already used your annual ISA allocation, you might next look at a High Street bank’s savings bond. Unfortunately these aren’t tax-free like cash ISAs or the certificates, but the best interest rates can be higher to compensate.

ICICI, the Indian Bank, is paying 4.75% on its five-year bond, while Chelsea Building Society currently has a bond paying 3% if you only want to lock away your money for two years.

These rates may have changed by the time you read this article, so shop around. Also check your deposit is protected by the FSA compensation scheme.

Note that you’ve no chance of beating the currently elevated rate of RPI inflation with these or Cash ISAs – or in government bonds for that matter. That’s the (steep!) price of security right now, and it’s what made Index Linked certificates so attractive.

Buy gilts and ‘linkers’ directly, in or outside an ISA

Gilts (government bonds) and National Savings certificates amount to the same thing – the Government borrowing money off its citizens.

The Savings Certificates were far easier for the average Joe to understand and invest into, however, and they also offered certain advantages: a fixed cash value (bonds vary in price over their lifetimes) and, crucially, a guaranteed positive rate of return for the Index-Linked certificates.

If you’re a fairly sophisticated investor, you can buy gilts yourself, either direct from the Government’s Debt Management Office or via your normal stockbroker (including online dealing accounts). There are costs in either case.

The five-year gilt yield is currently about 2.2%, so you’ll not get much of a return if you’re paying tax on the income. You’ll need to buy your gilts within your stocks and shares ISA to escape tax – and note that gilts must have at least five years to run at the time of purchase to be eligible to buy within an ISA (though once bought you can hold them in the ISA to maturity).

Remember: Unlike cash and the withdrawn certificates, the price of bonds fluctuates – so you may need to hold your bonds to maturity to ensure the capital you spent on your bonds is returned to you in full.

As for RPI-linked gilts, there is a three-year Index Linked gilt currently yielding 1.77% and a six-year Index Linked gilt yielding 3.18%. In addition to that yield you also get inflation-linking in the form of an uplift to the capital value of the gilts when they are redeemed by the government.

This uplift is free of capital gains tax, which may make them an attractive vehicle for higher-rate taxpayers fearing ever higher inflation.

Indeed, it makes linkers superficially very similar investments to the lost Index Linked Savings Certificates except for one crucial factor – you’re not guaranteed a positive return if RPI inflation falls over the life of the index-linked gilt.

In other words, if RPI falls from the currently high level that has bid up the price of these gilts, you could get less money back than you spent on them!

Personally, I think this risk makes them rather unattractive investments right now, but then I’m bearish on Government bonds in general.

There’s lots more information on index-linkers on the DMO website and you can get current yields from the Fixed Income Investor website’s bond tables.

Fixed and Index-linked gilt ETFs

Most people invested in National Savings certificates for the rock solid security offered by the Government, and for the regular interest payments.

However an investment in Government-backed debt is also an asset allocation decision, with many model ETF portfolios including a weighting towards fixed interest and index-linked government bonds.

iShares has a range of fixed income ETFs that also give you easy-to-buy exposure to UK government debt:

IGLS – tracks the performance of the Barclays ‘short maturity’ gilt index.

IGLT – tracks the performance of the Barclays all-gilt index.

INXG – tracks the performance of the Barclays index-linked gilt index.

These ETFs all pay various yields, but remember that unlike when you buy a specific gilt you cannot lock into a yield to maturity with an ETF.

Rather, the ETF is tracking a basket of gilts, so the yield will move as short gilts mature and are redeemed and new gilts are issued at the long end (i.e. with many years to run) at whatever interest rates are then prevailing. The yield on purchase will also vary as demand varies for the underlying gilts in the ETF.

The uncertain yield is probably fine if you’re looking to get exposure for pure asset allocation reasons (though again beware the currently elevated price of both fixed interest and index linked gilts).

But if you want to buy a guaranteed income stream, you’ll need to look into buying individual gilts.

An actively managed gilt or strategic bond fund

Yet another alternative is to buy an actively managed bond fund, where the manager argues he or she can add value buy trading gilts.

At today’s low interest rates on government bonds, however, it’s even harder than normal to recommend these funds, since management charges will devour much of your return from the low yields on offer.

We’re a very long way from the withdrawn certificates with these funds, to be honest.

A last word on the NS&I decision

I know I’m becoming the sort of person who says “market falls 1,000 points – great news for stocks!” but I can’t escape the feeling that the massive demand for these certificates is yet another sign of the bear-mania still prevailing.

It wasn’t that long ago you could get 5%+ from the fixed rate certificates, tax-free, with the Index Linked certificates paying much more interest on top of the RPI uplift, too.

Yet they’ve sold out at a time when the rates of return are derisory.

I don’t believe the public suddenly got smart. With shares still looking cheap in anything other than a persistently recessionary and/or deflationary environment, I think the demand from some 1.5 million customers for NS&I’s Index Linked certificates is much more about fear than opportunity.

That said, my backing equities over bonds hasn’t been a great call for most of 2010, and shares are a long term investment. You pays your money and you takes your chances.