Societies face challenge from National Savings: Maria Scott reports on the implications for savers and mortgage borrowers of the heightened competition promised by a new bond launch

SAVERS can expect a round of new offers from building societies in the next few weeks as these beleaguered institutions try to compete with the First Option Bond just launched by the Department of National Savings.

Investors committed pounds 15.8m to the bond in its first three days on the market. National Savings described the result as 'encouraging'. Several subscriptions were received for the maximum deposit of pounds 250,000.

The First Option Bond is paying 7.75 per cent net of basic rate tax on amounts between pounds 1,000 and pounds 20,000. Above that savers receive 8.05 per cent after tax.

The rate is fixed for 12 months. It is the first National Savings product to appeal directly to small savers paying basic rate tax. It is being sold through the post via newspaper advertisements at present but from 27 July will be available at post offices.

Although the rate is not as high as some expected and can be bettered by some building society accounts (see table), savers are likely to be attracted by the fixed return on a relatively small amount and by the rock-solid security of a Government-backed deposit.

With the economy showing scant signs of recovery and the stock market trading at around pre-election levels, deposit-based investments still hold considerable attractions. With the general trend in interest rates still downwards, though, it is hard to resist anything offering a fixed return.

A spokesman for Cheltenham & Gloucester Building Society, which consistently offers high- paying savings accounts, said the First Option rate, especially on pounds 20,000-plus, was 'too high for comfort' and added: 'We will be doing something very soon.'

Nationwide Building Society said it was considering how to react to the new competition. Last weekend the Nationwide withdrew a fixed rate bond.

However, building societies' ability to compete with the First Option Bond is limited. Their margins are being cut to the bone by the low mortgage rates they are offering to attract business.

Some societies, such as the Woolwich, are putting on a brave face, insisting that their product ranges stand scrutiny against National Savings. Donald Kirkham, group chief executive of the Woolwich, says: 'We think our investors want instant access to their money.'

This week the Halifax trimmed rates on five accounts - including its Tessa, Maxim current account and Cardcash accounts - for the second time since the last base rate cut at the beginning of May. The flagship savings accounts, Instant Xtra Plus and 90 Day Xtra remain unchanged.

The society said the changes were not connected with the National Savings bond and were merely 'minor adjustments to interest rates at the lower end of the investment product range'. This was necessary 'to maintain a prudent margin and profitability'.

Few building societies offer fixed-rate savings products at present, although the Halifax announced its Guaranteed Reserve last month in anticipation of the National Savings launch.

Halifax's bond pays between 7.125 per cent net of basic rate tax on pounds 2,000 invested for six months down to 6.75 per cent on the same amount invested for between two and five years. Rates are higher on pounds 10,000 plus but not as high as the National Savings bond.

It is possible to better First Option's rates with guaranteed income and growth bonds, but these are rarely available for a year on amounts as little as pounds 1,000.

Building society Tessa accounts also offer better returns than First (see Six of the Best, page 21) but only a few Tessas have fixed rates. Most are variable and have fallen steeply since they were launched. Also, investors must lock their money away for five years to get the high rate.

Returns on First Option for higher rate taxpayers are 6.2 per cent on between pounds 1,000 and pounds 20,000 and 6.44 per cent on pounds 20,000 plus. Higher rate taxpayers clearly do better out of Tessas and also out of the tax free 37th issue of National Savings Certificates, now paying 8 per cent tax- free. This is equivalent to 10.33 per cent gross.

National Savings 5th issue index-linked certificates pay 4.5 per cent tax-free over inflation. But all these investments have five-year terms, so some higher rate taxpayers may be drawn to First Option's one-year guarantee.

Non-taxpayers can buy First Option bonds, but this is not really a suitable investment since they cannot receive interest gross. Tax on First Option interest is deducted at source and non-taxpayers must reclaim it at the end of the year.

Investors can get their money out of the First Option Bond in the first 12 months but receive no interest. Withdrawals between anniversaries after that would attract half interest for the period from the previous anniversary.

People with mortgages could end up paying for the high rates being offered by National Savings.

Adrian Coles, head of external relations at the Building Societies Association, says that the pressure being put on societies' margins by competition from National Savings, and the difficulty they are having in attracting deposits to fund mortgages, would make it harder to cut the mortgage rate when the base rate next comes down.

Some lenders are hinting that they may have to reconsider their current mortgage rates, which have come down again this month, if they do not begin to attract more deposits.

David O'Brien, chief executive of the National & Provincial, summed up: 'If we have to keep savings rates high to fend off the competition from National Savings we will have less room to manoeuvre on mortgage rates.

'That will not help get the (housing) market moving, and those people caught in the debt trap waiting for house prices to move upwards will have to wait even longer.'

(Photograph and chart omitted)