Fixed interest rate or inflation-linked rate?

2011-09-03 00:00

IN recent times, the RSA Retail Savings Bonds (RSAs) have been tweaked by Treasury to offer more flexibility for investors. I have subsequently received e-mails from investors asking me which option is best: fixed interest rate or inflation- linked interest rate. I asked Daniel Wessels of DRW Investment Research to review these investments because the answer required some financial modelling.

These investments are designed to offer direct investors access to high interest rates paid to them by government. These products generally offer much better interest rates than those offered by commercial banks and are a serious alternative to fixed deposits for direct investors. Despite the initial scepticism of many, these investments are well managed by Treasury and I have received no complaints from anyone who has invested in them.

There are two basic categories of RSAs: fixed-term and inflation-linked. The fixed-term investments pay a guaranteed rate of interest for a specific period, eg two, three or five years. They are most similar to fixed deposits at a bank but the interest rates are generally much better than the banks. The second category of RSAs is the inflation- linked products. These products pay a specific rate of interest above inflation over three, five or ten years. These products are more complex because your interest payments will fluctuate with the inflation rate. In addition, your initial interest payments will be quite low but they will increase with inflation as will your capital.

What is important to understand about the RSAs is that they are offered to direct investors by the government. This means that trusts, companies and other legal entities cannot invest money in them. Because they carry no costs, any investor who wants a long-term allocation to cash should seriously consider the RSAs. While I am a massive fan of these investments, I wish Treasury would take the final­ step of making them tax-free as they are in other countries.

Wessels’s excellent research shows that there is no easy choice. Ironically, investments that have been designed to bypass the need for advice still require the input of experts. There have been times when the fixed-term RSAs have underperformed inflation significantly. This might lead investors to select the inflation-linked alternatives; however, at other times the fixed rates have handsomely beaten inflation. It is likely that fixed-rate RSAs will perform well when inflation is declining but will not do well when inflation is rising. If inflation spikes above expectations, fixed rate RSAs could actually underperform inflation which is problematic for investors.

To date, only one inflation-linked RSA has matured. When inflation was rising, the inflation linked option was better, but when inflation declined the fixed-rate option was better. This means that you will need to develop a view on inflation if you want to make a long-term investment in either option.

Wessels suggests that there should be little difference in returns from either option if you are going to make a long-term commitment. However, if you rely on the income from this capital, it is important­ to note that the initial income from the fixed-rate option is much higher than the inflation-linked option. Over the life of the fixed-rate option, your income will remain the same, while the income from the inflation-linked option will increase with the inflation rate. In addition, your capital will also increase with the inflation-linked option.

So, if immediate income is your main priority, you should seriously consider the fixed-rate option. If you are more interested in preserving your capital with minimal risk over the very long term, the inflation-linked option might be better.

 

• Warren Ingram, CFP (certified financial planner) is the Financial Planning Institute’s 2011 financial planner of the year. He is a director of Galileo Capital.

 

Join the conversation!

24.com encourages commentary submitted via MyNews24. Contributions of 200 words or more will be considered for publication.

We reserve editorial discretion to decide what will be published.
Read our comments policy for guidelines on contributions.

24.com publishes all comments posted on articles provided that they adhere to our Comments Policy. Should you wish to report a comment for editorial review, please do so by clicking the 'Report Comment' button to the right of each comment.

Comment on this story
0 comments
Comments have been closed for this article.

Inside News24

 
/News

Book flights

Compare, Book, Fly

Traffic Alerts
Traffic
There are new stories on the homepage. Click here to see them.
 
English
Afrikaans
isiZulu

Hello 

Create Profile

Creating your profile will enable you to submit photos and stories to get published on News24.


Please provide a username for your profile page:

This username must be unique, cannot be edited and will be used in the URL to your profile page across the entire 24.com network.

Settings

Location Settings

News24 allows you to edit the display of certain components based on a location. If you wish to personalise the page based on your preferences, please select a location for each component and click "Submit" in order for the changes to take affect.




Facebook Sign-In

Hi News addict,

Join the News24 Community to be involved in breaking the news.

Log in with Facebook to comment and personalise news, weather and listings.