We often see cautious clients who hold fixed rate bonds with their banks.  These are popular products with cautious investors since they allow you to benefit from a better rate of interest than you would otherwise get from your bank accounts, while still keeping the money safe.

This article aims to explain how these products work, and also to raise some issues you should consider before you buy into one.

Key points:

• How fixed rate bonds work
• Advantages and disadvantages of fixed rate bonds

How do fixed rate bonds work?

Fixed rate bonds are issued by your bank.  They work like a bank account except that you will lock your money away for a period of time, from a few months to up to 5 years.  In return, the bank will pay you a better rate of interest than they usually do in their standard savings accounts.  At the end of the period of investment the bank will return the money invested plus interest.  This interest is taxable.

They are popular products at the moment since interest rates are low, meaning savers are seeing their incomes reduced.  Cautious savers often see these products as a way to increase their rate of return.

How much better is the interest payable?

At the time of writing, the best 1-year fixed rate bonds pay out interest of around 3%.  By comparison, the best instant access account will pay you around 2.3%.  Both of these interest rates are taxable.  Is gaining an extra 0.7% interest (taxable) worth the downside of not having access to your money during that time?

Advantages of fixed rate bonds

• They pay a better rate of interest than normal bank accounts
• Interest is usually fixed
• The products are simple
• Your money is protected through the Financial Services Compensation scheme with UK registered banks up to £85,000 per person per institution

Disadvantages

• Rates
  While the rates of interest are usually better than standard bank accounts, they are not usually that much better. In the example above, if we assume you pay tax on your savings, if you had £50,000 invested in a bank account you might get £920 interest after tax per year; for the fixed rate bond quoted you might get £1,200 interest.
• Inflation
  At the time of writing the retail prices index for the UK stands at 3.2% (October 2012 figures).  Therefore if you pay tax on your savings, even with the best rates available to you, you still might be losing money versus the cost of living.
• No access
  This can be a major problem. Banks usually refuse access to fixed rate bonds during the investment period, although some do allow you to take withdrawals at a penalty.  A client recently had to take out a loan to buy a property since he could not access his money invested in fixed rate bonds as his bank refused him access to this money. This is a real problem, and you should consider whether you will need access to the money before you invest in such a product. Fixed rate bonds are not suitable for your emergency fund.
• Rising interest rates
  In a time when interest rates are rising, your fixed rate bond would not increase the interest paid.  Therefore, your money might be losing value.