Should you invest in Premium Bonds?

With a shrinking prize fund, are they still worth a bet

Premium Bonds. Your granny bought them for you when you were born, and since then the sepia-coloured certificates have been languishing in a drawer somewhere. Occasionally you fish them out to check for a big win, but you may have been disappointed for decades. It sounds like a crackpot way to use your money, closer to the National Lottery than an investment, but 23 million of us collectively hold a huge £39bn in Premium Bonds – and every month two of us win £1m.

Most people, however, are not so lucky. The majority of winners only take home the occasional £50, barely enough to ensure that your money keeps pace with inflation. Worse still, National Savings & Investments (NS&I) is planning to reduce the size of the prize fund and to introduce a new lower £25 prize category. Is it time to turn our back on Premium Bonds?

How they work

Premium Bonds are run by the Government-owned NS&I, and any money you invest in them is redeemable at any time. You can invest between £100 and £30,000, which is then broken down into individually numbered bonds worth £1 each. Each bond is then entered into the monthly prize draw – and will continue to be entered until you cash in your investment. Once you've invested, you'll receive a certificate for the total value of the bond you bought.

Each month, NS&I allocates a percentage of all the money invested in Premium Bonds to a prize fund. This percentage changes depending on interest rates. For example, at the moment, just 1.8 per cent of the money invested in bonds is being allocated to the prize fund, because the Bank of England rate has fallen to an all-time low of 1 per cent. Although NS&I has guaranteed to keep the prize fund at 1.8 per cent for this month and next, it will likely reduce the rate further in the spring.

The prize fund is then broken down into around a million prizes each month – ranging from £50 to a huge £1m, with two lucky bondholders bagging the top prize every draw. A handful of winners will receive prizes of £100,000, £50,000, £25,000, £10,000, £5,000, £1,000, £500 and £100 – but the vast majority of prizes are just £50.

Whether you win or not, your bond is entered back into the prize draw, and anything you win is free from both capital-gains and income tax. Anyone over the age of 16 can buy a Premium Bond.

Since the first Premium Bonds prize draw in 1957, more than 185 million tax-free prizes, worth £11.9bn, have been paid out. The prizes don't expire, so you can still claim your winnings years later. There are currently more than 570,000 unclaimed prizes, worth £33m, the oldest of which, a £25 prize, dates from the first year of the scheme, 51 years ago.

Playing the odds

If there is £39bn invested, and two monthly prizes of £1m, that means every pound invested has a one in 19.5 billion chance of winning the top prize every month. If you invest the £100 minimum, your chances rise to one in 195 million. If, by contrast, you buy a single ticket on the national lottery every week, you have a one in 14 million chance of coming up with six numbers and winning an average top prize of £2m. Over the month, that's odds of one in 3.5 million of winning £2m – compared with odds of one in 19.5 billion of winning £1m on each £1 of Premium Bonds.

And that's just the big wins. Every week, your chances of winning on the lottery are one in 1,033 for four numbers (worth around £62) or one in 56 of winning £10 with three numbers. In comparison, the current odds of each £1 Bond winning any prize starting at £50 is one in 36,000 every month. An investor with £1,000 worth of bonds has a one in 19.5 million chance of winning £1m, a one in 5.5 million chance of winning £10,000 and a one in 1.6 million chance of winning £1,000.

Obviously, the more you invest, the greater your chances. With £100, the chances of winning any prize this month is one in 360. Invest £1,000 and your chances increase to one in 37. Go the whole hog and pile £30,000 into Premium Bonds and you have a 56 per cent chance of winning something.

Of course, this isn't exactly a like-for-like comparison. National Lottery gamblers have to buy a ticket every week, and they don't get their money back. With Premium Bond, you only buy once, and are guaranteed your investment back whenever you decide to cash it in.

A moveable feast

The number and size of all but the largest monthly Premium Bond prizes are based on changing interest rates and the size of the total fund. You can cash in part or all of your bond at any time; if a bondholder dies, the investment is cashed in after a maximum of one year. If more bonds are encashed than newly invested, this could reduce the fund value, the total interest earned and, as a result, the prize fund.

And £30,000 is a lot of money to gamble with. Although the bonds are easy to cash in if you need the money, you may want to look elsewhere for a more reliable investment yield. Because you could win millions or nothing at all, it's difficult to work out if your rate of return is higher or lower than elsewhere. But a fund interest rate of 1.8 per cent doesn't compare well against the best savings rates on the market, even once tax has been accounted for.

Put the minimum £100 in an Egg savings account and you'll get 3.35 per cent, worth 2.68 per cent net to basic-rate taxpayers and 2.01 per cent for higher-rate payers. Investing the full £30,000 NS&I allowance in Abbey's two-year fixed-rate savings bond would give you a guaranteed return of 4.01 per cent gross, worth 3.2 per cent net for basic-rate taxpayers and 2.4 per cent for higher-rate payers.

Among cash ISAs, which have the same protection from income tax as Premium Bonds, £100 would give you a 5.5 per cent return through Abbey's Super Direct ISA, an instant-access account (which also requires, however, that you put the same amount or more into a qualifying Abbey investment). Thanks to the recent increase in the Financial Services Compensation Scheme limits, your money is protected up to £50,000 per organisation's banking license, offering a similar level of protection on your capital as the Premium Bond (provided you stay within this limit).

Staying in

The bad news is that rates of return on Premium Bonds are about to get worse. NS&I has said that it will keep the prize fund rate at 1.8 per cent through March, but it may well drop it in April. As rates of return fall, more investors are likely to cash in – further reducing the prize fund.

So far, NS&I maintains, levels of redemptions have been relatively low. "We are not seeing a significant change in the number of people pulling their investments out of Premium Bonds," says Gill Stephens, a spokesperson for NS&I.

But NS&I may also start awarding £25 prizes – half of the current minimum – in periods of low interest rates. Such prizes, Stephens admits, could replace some larger awards, potentially reducing the incentive to invest. "It is likely that there would be fewer £50 or £100 prizes" if £25 prizes are introduced, she says. She points out that the measure would ensure a steady stream of prizes despite lower interest rates.

The drop in interest rates meant the total prize fund for December 2008, split between more than 1 million prizes, was just under £58m – less than half the previous December's prize fund of £119m.

"People get very comfortable with Premium Bonds," says Hugo Shaw, an investment manager at the independent financial advisers Bestinvest. "A reasonably steady flow of £50 prizes and the possibility of a big win has kept people from cashing in. But investors should always treat Premium Bonds as a low yield. You could win a big prize, but don't ever rely on it. With interest-rate rises expected, we will have to see if the rate on the prize fund responds fast enough. If it doesn't, people should consider looking elsewhere for more reliable returns. And if you have surplus capital you should always use your tax-free ISA allowance in the first instance."

For more information or to invest in Premium Bonds, go to www.nsandi. com or call 0845 964 5000. Bondholders can check for winnings at www.nsandi.com/products/pb/haveyouwon.jsp

Safe as the Bank of England: How to choose the right bond for you

For the same level of investment protection, premium bond investors have several options to consider.

NS&I's own savings certificates are also tax free and backed by the Treasury. Its two-year fixed-rate savings certificates currently offer a return of 0.95 per cent, or for five years the rate increases to 1.90 per cent; or, the index-linked savings certificates offer the Retail Prices Index (RPI) rate plus 1 per cent (currently a total return of 1.1 per cent) for three or five years.

But investors could also buy government bonds, or gilts, which offer a cash payment every six months until the maturity of the bond, at which point you get your original investment back. The most widespread, conventional gilts are named according to their fixed yield and maturity date: for example, 4 per cent Treasury Gilt 2012, will return 4 per cent interest a year until 2012 when the bond matures. For index-linked gilts, the semi-annual payments are linked to the RPI and fluctuate. You can buy these directly from the Government's Debt Management Office (see www.dmo.gov.uk for more details).

Elsewhere, putting your cash into high-street savings not only gives you protection up to £50,000 under the FSCS, but if your savings go into Northern Rock, which is owned by the Government, your money is once again in effect backed by the Treasury.