Why do fixed rate ISAs pay lower rates than bonds? - ISAs - News - Moneyfacts

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Why do fixed rate ISAs pay lower rates than bonds?

Why do fixed rate ISAs pay lower rates than bonds?

Category: ISAs

Updated: 01/05/2014
First Published: 14/09/2012

MONEYFACTS ARCHIVE
This article was correct at the time of publication. It is now over 6 months old so the content may be out of date.

Ever wondered why sometimes the top fixed rate ISAs pay a lower rate of interest than an equivalent fixed rate bond?

You should get out more! But the answer is at hand, and actually, it's surprisingly simple.

At present the top 5 year fixed rate bond pays 4.50% AER, while the best equivalent fixed rate ISA pays just 4.05% (based on an investment of £5,640).

In fact, if you look at the top 2, 3 and 4 year fixed rate ISAs, all have interest rates that are quite a bit less than the top bond rate available. The exception to the rule is 1 year fixed rate ISAs, where rates are currently on a par with 1 year bonds at 3.25%.


Top Fixed Rate Bond (AER) Top Fixed Rate ISA (AER)
1 Year 3.25% Post Office® 3.25% Metro Bank
2 Year 3.51% Post Office® 3.30% Santander
3 Year 3.85% State Bank of India 3.75% Halifax
4 year 4.20% State Bank of India 3.80% Halifax
5 Year 4.50% State Bank of India 4.05% BM Savings
SOURCE: Moneyfacts.co.uk 13.9.12.
Based on an investment of £5,640 (the maximum cash ISA allowance for 2012-13).

Of course, looking at top rates is only taking into account the extremes of the market. If we look at average rates though, bond and ISA rates aren't actually that far apart. In fact, ISA averages are higher!

Average Fixed Rate Bond vs Average Fixed Rate ISA (as at 13.9.12)
1 Year 2 Year 3 Year 4 Year 5 Year
Bonds 2.54% 3.01% 3.18% 3.39% 3.60%
ISAs 2.73% 3.05% 3.19% 3.53% 3.84%

Fixed rate ISAs and bonds are different

We said at the beginning that the answer would be surprisingly simple!

The easy (and completely wrong) assumption to make is that fixed rate ISAs and equivalent fixed rate bonds should be paying the same rate. But while both pay a fixed rate of interest over a set term, there are subtle differences that make the markets very distinct.

If we look at the top fixed cash ISA rates for instance, and then look at that provider's top fixed rate bond, the rates differ surprisingly:


Top Fixed Rate ISA (AER) Equivalent Fixed Rate Bond (AER)
1 Year 3.25% Metro Bank 2.75%
2 Year 3.30% Santander 3.00%
3 Year 3.75% Halifax 3.25%
4 year 3.80% Halifax 3.50%
5 Year 4.05% BM Savings 3.90%
SOURCE: Moneyfacts.co.uk 13.9.12.

Far from offering equivalent bonds with higher interest rates, the top fixed rate ISA providers actually offer equivalent bonds that are lower! This illustrates the fact that the two markets are distinctly different, and that while a provider might be more competitive in one market, they may not necessarily choose to be so in another.

Why do rates differ between bonds and ISAs?

There are several reasons why the top interest rates on the top fixed rate ISAs are currently lower than on the top bonds:

  • Fixed rate ISAs have to allow transfers
    A fixed rate bond provider does not have to allow you access to your money during the term (and indeed, many best buy bond providers don't). This means that the provider has the certainty of knowing it has the use of your money for a set period. In contrast, a fixed rate ISA provider does not have this certainty as it has to allow you to transfer out of the ISA at any time. Although an interest penalty will undoubtedly be charged, this lack of certainty may be reflected in the pricing of the interest rate.

  • ISA competition is very seasonal
    Competition among fixed rate ISA providers tends to hot up around the end and beginning of the tax year, as investors flock to use their cash ISA allowances. In the "off-season" rates tend to be less competitive.

  • Top fixed rate bond providers not offering ISAs
    Currently, the market leading bond providers for 2 years and over don't offer cash ISAs. Many of the best buy top spots are occupied by new banks that haven't entered the ISA market.

  • Deposit levels
    ISAs are a legal way of avoiding tax. You can shield up to £5,640 from the tax man in a cash ISA in the 2012-13 tax year. Conversely you can deposit far higher sums into a fixed rate bond. Higher deposit levels mean that some bond providers are prepared to offer higher interest rates.

To conclude…

The cash ISA and savings markets are different, so it would be wrong to think that interest rates should necessarily be the same.

The additional cost of offering a fixed rate ISA – including back systems and allowing a customer to transfer money out before the end of the term – means that an ISA is a more expensive product to run. This may well be why the make up of fixed rate ISA and fixed rate bond best buys are so different, as many top-paying bond providers have not entered the fixed ISA market.

Appetite for longer term bonds and ISAs is smaller than for shorter term options. Competition for 1 year fixed rate ISA customers is such that on average, they actually pay a higher interest rate than 1 year bonds – and have done so for the last 12 months.

Although interest rates on longer term ISAs are lower, it should be remembered that a fixed rate ISA is still likely to give a higher return than an equivalent bond, as the interest you receive is tax-free. So while the top 5 year fixed rate bond pays 4.50%, that rate is only 3.60% if you pay basic rate tax, or just 2.70% if you're a higher rate taxpayer. So the top 5 year fixed rate ISA at 4.05% is still one of the best savings rates you can get if you pay tax.

What next?

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Disclaimer: Information is correct as of the date of publication (shown at the top of this article). Any products featured may be withdrawn by their provider or changed at any time.

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