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

by The Investor on July 21, 2010

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to put their money into National Savings certificates have suffered a big setback; National Savings & Investments has withdrawn all its index-linked and fixed interest Savings Certificates from sale.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Interest Savings Certificates and Index–linked Savings Certificates, also known as Inflation-Beating Savings) have been withdrawn from general sale and that it is reducing the interest rates paid on its Direct Saver and Income Bonds by 0.25% with immediate effect.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.

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Weekend reading: On the road

by The Investor on July 17, 2010

My regular roundup of decent reads.

I have to get stuck right in this week as I’ve a crazy early train to catch. (I’m off to a rain lashed house in the provinces to kitten-sit. Really).

[continue reading…]

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Beware the lure of the exotic

by The Investor on July 15, 2010

Some people find complicated financial products compelling. Especially financial advisers peddling a hot new fund for commission.

If there’s a whiff of the exotic thrown in, so much the better.

A person who knows nothing about Indonesia, Brazil, or South Africa will confidently tell you that these countries offer much better returns than the domestic market.

Ask them why and they’ll point to our aging population, political sclerosis, or rising public debt.

Typically they know nothing about the problems of the alternative countries. It’s just that the exotic unknown is more attractive than the all-too-familiar reality at home.

Sophisticated isn’t complicated

Overseas investing is a good idea, sure.

But that’s as part of a diversified portfolio, not as a punt on crackpot Internet theories about the demise of the West.

Other people assume complex products and ambitious strategies must be superior to a tracker fund.

Why shouldn’t they be? More expensive computers are better than cheap ones. Famous lawyers are superior to also-rans.

But investing is counter-intuitive. Paying more usually means worse results, because active investing is a zero sum game where the only certainty is higher fees.

Typically the investors they attract will waste money paying for a poorer performance from funds that promise to outperform, or else from absolute return funds that cap returns and rake off the upside but don’t entirely protect the downside.

At worst, they’ll put money into the next Bernie Madoff-style Ponzi scheme.

They hear other clever people are doing so, and the fact that it’s a black box makes it more attractive to this kind of mindset, not less so.

We all love mysterious strangers

Generally however, it’s best to keep things simple when investing.

When you become more interested in wealth preservation than in growing your nest egg you might try some risk-aversion strategies.

But in your core saving years a simple ETF portfolio is probably your best bet.

Whatever you do, avoid rushing into exotic funds just because they sound sexy.

Of course, nobody puts money into something just because it sounds sexy. That would be dumb.

No, rather like a country maiden stumbling into the path of Don Juan, they fall for the sexy talk:

The fancy brochures or snazzy website
The impressive back-tested returns
The puffy articles in the financial press
The high-blown talk of commodities or futures or frontier markets
The nifty name dreamed up by a guy with a cool hair cut

Most of this stuff is just pretty words.

There’s nothing really new under the sun in investing. If complicated strategies were better, we’d know already.

What we do know, rather, is that passive index tracking is usually best.

The unfamiliar is appealing

It’s too easy to be swayed by the superficially different.

I was reminded of this by a recent advert from the oil producer Shell. It portrayed a camera-friendly Japanese family going about their life of burning fossil fuels and polluting the planet.

Obviously the ad focuses on the domestic end of this particular value chain, mind you – all hugs and home furnishings.

[Update: I used to have the advert embedded here but the video has been taken down in the years since publication. Fashion changes, eh?]

I loved this ad when I first saw it. The combination of exotic location, mysterious utterances, and its surging guitar riffs made my spine tingle.

You can imagine my disappointment then when I did a bit of research via Google and found the truth rather duller than the fictional reality.

What does the protagonist Mr Ohashi utter to his wife, I had wondered?

“I fear the return of Godzilla,” perhaps? Or maybe: “Will this day end in darkness?”

No. He just says about his son: “What is he doing?”

And what about the sage, sweet murmuring of his wife?

She says: “It’s because he’s a kid.”

Not much poetry in that.

Finally, I used Shazam to discover who recorded the guitar riff.

I expected to discover some incredible Japanese hardcore band, but it was actually recorded by a U.S. novelty group called Green Jelly.

Even worse, it’s just a version of the children’s song The Bear went over the mountain, to see what he could see. (He sees the other side of the mountain…)

Don’t believe the hype

If this advert was filmed in rainy Croydon, in English, with the music rattling only a pair of ancient Charles and Di wedding mugs and the tune replaced by Slade singing Humpty Dumpty, then nobody in Britain would fall for it.

Perhaps that’s the version they show in Tokyo?

Think about it the next time you’re tempted to put money into some complicated, exotic sounding financial product on the back of its mysterious charms.

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The risks of buying mark to market investments on margin

by The Investor on July 13, 2010

This is part of my series on why borrowing to invest is usually a bad idea.

A mark to market investment is one where the price of a security (or a company or other recently valued asset) gives an accurate appraisal of its current financial worth.

For instance, a company’s share price tells you what buyers are prepared to pay for it right now. We can call this the market price.

The company may own assets in excess of the value implied by its share price, but the company’s valuation is marked to market by what traders are currently willing to pay for its shares.

Value investing involves looking for assets that are worth more than their market price. It requires patience, because it can take time for value to be ‘outed’ – that is, for the market price to tally with the company’s true value.

Mark to market, mortgages, and borrowing to invest

One reason why using a mortgage offers the best hope of making the maths work if you borrow to invest is because mortgages are the cheapest form of debt.

But another key advantage of a mortgage is that your house and your debt is not marked to market.

This means that if the Daily Mail reports house prices have fallen by 10%, you won’t be expected to stump up an extra £30,000 by your bank.

i.e. You won’t face a margin call to avoid being kicked out of your house just because your house’s price has fallen while your debt is unchanged. Negative equity only matters if you need to sell and you can’t repay your mortgage.

If you have a mortgage while investing in equities then you are effectively borrowing to invest, because the money you use to buy shares could instead be used to pay off your mortgage.

Most of us do this, if only because we have pensions. We get away with it because any declines in our share portfolios don’t force a margin call on the mortgage on our homes.

Indeed, some people go a step further by using an interest only mortgage to try to invest their way to repaying the capital they owe their bank. This is much riskier, as there’s no guarantee their investment will grow sufficiently large to cover the outstanding capital payment on the house at the end of 25 years.

Mark to market and spreadbetting

In contrast to a mortgage, a spreadbet is a good example of a mark to market loan that can be extremely expensive if you can’t meet the margin calls, let alone all the other magnified risks of investing with borrowed money.

With a spreadbet, you put down say a 20% deposit to trade a particular share on margin. The other 80% of your holding is bought via a loan. (The interest cost is wrapped up in the ‘spread’).

For example, let’s say you want to take out a £1,000 position in a share via a spreadbet. You put down £200 (20% of £1,000) as you place your bet.

Now imagine the share price drops 10%. Your position is now worth £900 — and you’ve lost £100.

You will therefore face a margin call to maintain your 20% deposit ratio, which means the spreadbetting company will immediately ask you to add extra money to top up your position.

In this case you’d need to add £80 to get to £180 (20% of £900) to stay invested.

Given how volatile equities are, such mark to market factors can easily kill your bet. You will either face a margin call or be kicked out of your investment when prices fall, and if you do sell then you’ll likely be too slow or scared to get back in before prices rise again.

Equities are too volatile for short-term borrowed money

When you borrow to invest on margin, you are at the mercy of the short-term. Yet the volatility of equities can only be tamed by taking a long-term view.

Spreadbetting is therefore risky not only because you are borrowing to invest and might lose money you don’t have, but also because mark to market can shake you out of positions that go against you in the short-term, even if your long-term call is good.

No wonder more than 80% of spreadbetters lose money.

We discussed above how your bank won’t bother you if property prices fall provided that you keep paying your mortgage.

That your bank doesn’t think it’s worth the risk to give you the same terms to invest in equities should set alarm bells ringing about the wisdom of borrowing to invest!

Footnote on spreadbetting

It is possible to spreadbet in shares fairly safely, if you reduce or entirely avoid leverage (debt) by offsetting your spreadbet portfolio with an appropriately sized cash savings account. You might do this to avoid Capital Gains Tax, for instance. It’s a fiddly subject, though, and one that will require an article in its own right. Watch this space!

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