Premium Bonds: a better bet for savers when interest rates are low

Cash is a crucial part of a portfolio. It provides you with reserves to draw on for large planned or unplanned expenses, and it allows you to take advantage of any major buying opportunities in the markets. How much cash you hold as part of your investments – as opposed to what’s in your current account to cover routine outgoings – will vary depending on the size of your portfolio, the level of your regular, reliable income and whether you are expecting any major outlays in the next couple of years, but many people keep between 5% and 10% of their assets in cash.

Unfortunately, cash also seems dull. The interest you can earn is usually modest compared to the potential returns on other assets. At present, with inflation likely to stay high and interest rates firmly on the floor, you are guaranteed to lose money in real terms: UK inflation was 2.4% in June, compared with a best rate of about 0.5% on an easy access account and 1% if you lock your money up for a year. So the temptation today to move your cash into higher-yielding investments is huge. The problem is that investments with a higher potential return carry more risk to your capital, and the point of cash is to have complete security and easy access. 

Popular, but normally not attractive     

However, there is one popular investment that probably looks better in today’s conditions than usual: the government-backed National Savings & Investments Premium Bonds. These don’t pay interest – instead they run a monthly prize draw, with an annual prize rate that varies over time to reflect what’s available on savings accounts. This rate is now 1%, down from 1.4% last year. The tax-free prizes range from £25 (where each £1 Premium Bond has a roughly one in 35,000 chance of winning) to £1m (about one in 55 billion). You can save up to £50,000 and there’s no notice period for withdrawals.

That 1% prize rate doesn’t represent the typical return, because it’s skewed by the handful of large prizes. Your expected return depends on how many bonds you hold. A saver who has £1,000 is unlikely to win anything in a year. One with £35,000 will average one £25 prize each month (an annual rate of 0.85%) – but around half of savers will do worse.

Lumpy returns like this make Premium Bonds fairly unattractive in normal conditions. But with interest rates so low relative to inflation, even the unlucky won’t end up much worse off than with a savings account. The capital is safe and there is a tiny probability of a bigger payoff. Very few investments that have that risk profile. So long as the prize rate stays competitive against savings, Premium Bonds can be a simple way to make cash a little more exciting without adding risk.