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.


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