Cannier ways to juggle with your cash

Investors who wish to withdraw money at short notice can use a variety of schemes: from bank deposits to bonds and TESSAs
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The Independent Online

"Cash" is the shorthand name for bank and building society deposits that can be withdrawn at relatively short notice, normally a maximum of 12 months. They earn a regular income, and they are generally very safe, but they cannot be bought and sold or generate a capital profit.

"Cash" is the shorthand name for bank and building society deposits that can be withdrawn at relatively short notice, normally a maximum of 12 months. They earn a regular income, and they are generally very safe, but they cannot be bought and sold or generate a capital profit.

Cash can be withdrawn from current accounts quickly and easily but the interest rate is usually subject to change at short notice at the borrower's discretion, and most current accounts pay interest rates well below base rates and the current rate of inflation. When base rates were in double figures that did not matter too much but at current levels current accounts generate derisory amounts of interest, often less than one per cent.

Investors who notice generally complain bitterly at low rates of return, while banks argue that after covering the costs of their branch networks they don't make much profit re-lending money they get from ordinary customers. But by looking around for competitive rates, and by locking cash away for fixed periods, it is possible to get up to 7 per cent a year.

Cash ISAs are a better bet for savers with up to £3,000 a year to tuck away. They pay good rates of interest, and they have the additional advantage of paying interest tax-free. Unlike TESSAs, the tax-free concession is not lost if the cash is withdrawn, although the balance cannot subsequently be topped up again once it has been withdrawn.

Another option is to invest in cash unit trusts run by professional managers that take the small sums they get from individual investors and reinvest in the London money markets, or buy Treasury and commercial bills which pay better rates to large investors with millions of pounds to lend. Another alternative is to invest in a deposit paying a fixed rate of interest for a fixed period of time, which could be up to five years. At any one time a fixed rate deposit will usually earn more than a variable rate, but if variable rates rise being locked into a fixed rate is not a good place to be. Another possibility is to invest in deposits denominated in foreign currencies such as dollars or euros, which offer the possibility of making profits and losses on the currency rates as well as earning interest. But the reward should be enough to balance the extra risk.

Cash investments by definition offer no direct protection against inflation, but interest rates do tend to rise with inflation and offer at least partial compensation. Because high interest rates are generally damaging to other kinds of investment, cash deposits offer a valuable way of diversifying a portfolio and reducing the overall risk.

Government stocks and corporate bonds are the second level of investments. They are essentially pieces of paper that promise to pay fixed amounts of interest normally twice a year and to repay the capital in full at a set time in the future, usually at least five and often as long as 25 years away.

Unlike cash deposits they can be sold through a stockbroker and turned into cash within a few days, but the downside is that unlike an instant access deposit that can be withdrawn in full, a stock or bond can be sold only for its current market value. If the current level of interest rates is less than the fixed interest payable on the stock or bond, the bond or stock will have gone up in value and the investor will get more than they paid. But if current interest rates are higher than the interest payable on the investment, its market value will be less than its face value.

The current return on a fixed interest investment can be measured either as the running or current yield, which is the annual interest as a percentage of the current price, or the redemption yield, which adjusts the return for the capital gain or loss the investor would make by holding the bond until it is repaid. If the redemption date is very close the gap between the current and redemption yields will be small but if the redemption is years away and the fixed coupon is out of line with current interest rates the gap could be quite large.

Fixed interest stocks are also especially vulnerable to inflation. Unlike cash deposits the interest they earn does not rise with inflation. Government bondholders are guaranteed they will get their money back in full if they wait until the bonds reach their set maturity date, but corporate bonds involve a slight but significant risk that the company will go bust and the capital will be lost. To adjust for the risk corporate bonds normally have a higher coupon and are priced to provide a better running yield than government bonds.

Some bonds offer high coupons because that was the going rate when they were issued, but as a general rule the higher the coupon and the higher the current yield the greater the perceived risk of a loss, and the bonds with the highest yields are often referred to as junk bonds, because of the possibility they will become just that. As investments in a portfolio, bonds are riskier than cash because they are more exposed to inflation, and over time are not that much more rewarding. But bonds did perform well in the 1990s because the outlook for inflation improved, and they are an essential ingredient in the portfolios of all pension funds.

No review of fixed rate investments is complete without a reference to index-linked securities issued mainly by the UK government over the last 30 years. Because the value of the capital and also the annual dividend income is protected against inflation they appreciate in value and are redeemed at whatever they are worth when the time comes, but they pay lower rates of interest than ordinary bonds. They are less attractive now that inflation has been brought under control but they are still a potential part of a very low risk investment portfolio. It is also important to remember that all bonds have one useful advantage over shares. Any capital gains will be exempt from capital gains tax.

Next week we look at shares and property, investments that involve higher risks and offer higher returns, but are essential components of any long-term portfolio that seeks to keep pace with inflation and the growth of the economy as a a whole.

* Clifford German is a joint author with Arun Abey and Ean Higgins of Fortune Strategy, recently published by Pearson Education.

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