Three ways to beat inflation

It's tough being a saver right now. The hard truth is that, if you have any cash in the bank, it is almost certainly losing its value, once you take inflation into account. With the Retail Price Index (RPI for more on this, see page 44) at 5.2%, a basic-rate taxpayer needs to be earning more than 6.5% before tax to break even, while for a 40% higher-rate taxpayer the figure is a shade under 8.7%. There are no bank accounts that will pay you that kind of money. The good news is that there are some options for investors who want to guard against inflation without taking the risk of putting their money in equities.

Firstly, there's the government owned National Savings and Investment (NS&I) bank. NS&I is attracting a lot of attention just now. That's because it has recently released some new five-year, index-linked certificates. These pay the annual change in the RPI plus a fixed 0.5%. Better still, the return is tax-free, so regardless of your tax bracket, you'll beat inflation. So far, there's not much not to like.

But while many pundits expect inflation to rise over the next few years, it's possible that it won't. That's what the Bank of England is hoping at least. The Bank has so far avoided raising interest rates even though the Consumer Price Index (CPI an alternative cost-of-living measure) is rising at 4.5% a year, well above its 2% target. While NS&I certificates are a great way to keep on top of inflation, they're not such a good deal in terms of the absolute return offered should inflation fall sharply. Besides, once you've used up your £15,000 allocation, that's it. Those with an appetite for a bit more risk may want to look at two Royal Bank of Scotland (RBS) retail bonds listed at the London Stock Exchange as alternatives.

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An each-way bet on inflation

The first RBS bond (LSE: RBPI) offers some inflation protection, but also a minimum return should inflation drop. The deal, in income terms, is simple you'll get the RPI rate or a fixed 3.9%, whichever is higher. The way the inflation linking works is that at the end of every quarter RBS takes the level of the RPI two months previously and looks at how it has changed on the year (the time lag means the figures are published and unlikely to be revised so your quarterly coupon is a known amount). So right now the bondpays a quarterly coupon of the RPI rate, multiplied by the nominal value of the bond (think of nominal value as being like a kilo of potatoes it's a known, fixed quantity of a bond). If, on the other hand, RPI inflation fell below 3.9%, you'd get a coupon of 3.9% per £100 nominal value.

So if the bond trades at £97 per £100 nominal value (just as the price of a kilo of potatoes can vary, the price of a bond will vary too); and the RPI stays at 5% over four consecutive quarters (in practice it will change); you would receive £5 a year. With the bond trading at £97 per £100, that's an income yield of 5/97 x 100%, or about 5.2%.

To maximise this income, the best bet is to hold the bond in an individual savings account (Isa) wrapper corporate bonds are eligible as long as they have a remaining maturity of at least five years, which this one does: it doesn't mature until 2022. That way the income you get is tax-free as is any capital gain. A capital gain would arise if you either buy the bond for, say, £95, and sell it later for more (the price will fluctuate according to supply and demand), or you hold it until maturity in 2022. At that point the issuer, RBS, will buy it back for its nominal value of £100. You can also put the bond into a self-invested personal pension (Sipp).

A few things to watch

So, what are the catches? Unlike an NS&I account your capital is not guaranteed by RBS. There are two ways it could be threatened. First, RBS is currently owned by the government, but that may change in the future. The chances of it going bust may still be fairly small (the bond is, after all, A+ rated, so pretty near the top of the ratings agency scale), but it does not enjoy the zero risk of being NS&I-bank-backed. Also, any amount invested falls outside the safety net provided by the Financial Services Compensation Scheme (FSCS).

Next, bond prices do move up and down, albeit they tend to be less volatile than equities. So were you to buy the bonds for more than £100 per £100 nominal value, you would lose some capital if you had to sell them for less, or simply waited for redemption. On the flipside you could make a capital gain if you buy and the price subsequently rises, or if you buy for below £100 and can wait until maturity.

And, of course, if inflation does force the Bank to raise interest rates sharply in the future, you may find that at some point you can get a better return on an ordinary bank account than on this bond. That said, I think the slight risk to your capital is compensated for by the 3.9% floor. That fixed return (potentially tax free inside an Isa) could be very attractive in a period of deflation.

A bond for serious inflation bulls

For anyone who isn't at all worried about deflation, RBS has an alternative offering the inflation-multiplier bond (LSE: RBPX). The bond matures in 2020, slightly earlier than the one above. Again, you get a quarterly coupon linked to the RPI. But in this case, if the RPI change is positive year on year, you get 1.3 x the rate. If it is zero, or below (deflation), you get nothing by way of a coupon. So with the RPI at 5.2%, you are looking at a coupon rate of nearly 6.8% (per £100 nominal value held). With the bond trading at around £98 at the time of writing, the yield is around 7% and if you put it in an Isa, you get that tax-free. Obviously, the downside other than the general ones highlighted earlier is that should inflation fall sharply there's no 3.9% floor on this issue.

If it's absolute safety you're after, stick with NS&I. Otherwise these RBS bonds are attractive, if you can put them in an Isa. On balance, I'd favour the deflation-hedged option, but if you're firmly in the inflationist' camp, option two is best.