DIY investor: A premium bond resurgence

October 13, 2016
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There can be few investment nerds anywhere who are still unaware that $10 trillion or more of government bonds now carry negative yields—in other words, if you buy one the total amount you will get back at maturity, including all interest payments, will be less than the price you paid. Out of this pre-eminent oddity many others flow.

One is that rarely, if ever, have pundits written so frequently about cash, which in normal times is regarded as the raw material of investment, to be traded gladly for something more profitable. Now, instead of being seen as a means to an end, cash has become an investment in itself. When the income from a 10-year German government bond and a €100 note are both zero, as Richard Woolnough of M&G recently pointed out, why risk buying a bond that could fall in value?

All this has prompted me to think again about one of the UK’s most popular cash investments: premium bonds. In the past, I’ve not been very keen on them as the prizes don’t add up to much of a return (1.25 per cent on average since June this year, down from 3.4 per cent as recently as May 2008) and because inflation has steadily eaten away at the value of the £1m jackpot since it was introduced in 1994. I used to believe people were seduced into low-yielding premium bonds by misplaced optimism that “it might be them.” As a result, they gave up the opportunity to earn higher but less exciting returns from other sources. Why the change of mind?

If in our 0 per cent world nothing else will pay me a small but safe return, then premium bonds are a reasonable option. They’re guaranteed by the government, tax-free and they might—just possibly—bring me a large cash windfall. My point is that in the past, savers who were induced to buy premium bonds by the vanishingly small prospect of winning £1m paid a penalty for their irrational optimism in lost interest income. Now they don’t.

I can’t do much better than 1.25 per cent a year with instant access anywhere else and therefore the penalty for optimistically holding premium bonds in order to have a chance of a £1m payday has all but vanished. To put it in nerdier terms, the price of buying an option on the very remote possibility of winning £1m has fallen to zero. In those circumstances, why not buy it?

In fact, why not apply the premium bond model more broadly? Now that we live in an era when nobody wants to pay savers any interest at all, how about a savings account that doles out a few big but random windfalls each month and gives everyone else nothing, instead of paying an equally meaningless rate of interest to everyone? I suspect an account like that would attract plenty of deposits and that ultimately it would deliver virtually free long-term deposit funding to the bank. It would certainly be more exciting for the customers.

In a world full of financial oddities this is one that, to me at least, has started making sense.