Several providers have recently launched guaranteed return products. And some are paying a surprisin...
Several providers have recently launched guaranteed return products. And some are paying a surprisingly high level of guaranteed income such as the 10.25% rate on offer from Scottish Widows' Extra Income & Growth plan Isa.
While providers are not allowed to use the word guaranteed, as the capital is not protected fully, the product does provide high income or capital growth levels.
It also gives capital protection by investing in a basket of shares and the value of these shares has to fall by over 20% before you see a capital loss.
But with an uncertain outlook for interest rates and the stock market, combined with recent press coverage on the disappointing return from a recently-matured one year bond from Abbey National, is now a good time to recommend these bonds to your clients? In essence, it comes down to whether you think interest rates are going to go up or down.
One way of gauging the future level of interest rates is to look at the yield curve. This shows the yield payable on government securities, the majority of which pay interest for fixed periods of time with maturity dates of between a few months to more than 30 years. The gilts are traded in the market and the price that people are prepared to pay dictates what the effective yield on them will be. If the price of a gilt increases, the corresponding yield decreas-es. By drawing the yields of the various gilts against time, it is possible to show what the market thinks interest rates will do in future.
What government does is also a major factor. If it decides to go on a spending spree prior to the next election, this could increase inflation. As the Bank of England is now independent, it would have to raise interest rates to stem this rise. The Government reputedly has a large war chest ready for the election, so this could well happen, in spite of the Chancellor's insistence on prudence.
Alternatively, as happened recently, the Bank of England can alter the base of its inflation forecast to match the Government's target, meaning it does not have to change interest rates.
Pension funds can counteract this as they are obliged to buy gilts, considered to be safe investments, as part of their minimum funding requirement. But as the Government has not been issuing many gilts in recent years, they are in short supply, and as the price goes up the yields go down.
The Government is not issuing many gilts because of the amount of money it has received from taxes, which brings us onto the next area of uncertainty, the Government itself. If it has a major change of policy, or indeed if the ruling party government changes, this can have a massive impact on interest rates.
Another major influence on inflation, and therefore on interest rates, is what commentators call consumer confidence. When consumers are feeling safe in their jobs and happy, they tend to spend more. This leads to inflation as more money starts to chase fewer products.
In this scenario, as a net importer of consumer goods, we have to sell sterling to buy foreign currency to buy the goods.
The effect of this is to weaken sterling: more pounds are required to buy foreign goods, pushing up the price and causing inflation.
Conversely, because of the current strength of the pound against the euro, imports from euro countries are cheaper. Inflation will not go up, as costs to retailers remain static or fall, which might mean that short-term interest rates will be reduced.
Of course if the UK did join the euro, we would have to have economic convergence with the rest of Europe. As Ireland has found, this would mean we would have to reduce our rates to bring them into line with Europe, even though this might not be the best thing to do in the short term.
The oil price acts as a real wild card. An increase in this causes a rise in inflation, but causes a decrease in consumer spending on other goods. As the UK exports oil, it also brings in more revenue to the Government, which means that less borrowing may be necessary.
If interest rates come down, this could cause the stock market to rise, which would reduce the downside risk of an investment bond's underlying shares falling. This is not only because investors will be more attracted by the yield on shares, but also because low interest rates help companies increase their profits as their borrowing costs are reduced. In this case, however, where the stock market rises significantly, customers may do better by buying a different product, such as a tracker fund or investing directly in the stock market, where there are no upside limits to growth.
So is it worth buying a product such as the 10.25% Scottish Widows Extra Income & Growth Plan?
It is difficult to predict interest rates, but overall it looks like, barring any unforeseen circumstances, they will go down or remain about the same, reducing the risk of capital loss at the end of the term. But at the end of the day, one can never be sure and like so many things, you have to pay your money and take your chance.
Graham Johnson is managing director of InterMutual Financial Services
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