Coping in a low interest rate climate

For savers, these are tough times indeed. With interest rates so low - the base rate currently stands at 4.75%, the lowest for 40 years - the traditional bank and building society account is no longer a viable source of returns.

Nor can savers expect rates to rise in the near future given the current unstable political and economic environment, and the aggressive rate cutting of the US Federal Reserve. Indeed, if anywhere, interest rates are likely to head even further south.

So what are the options for people who can't stand the thought of their money stagnating on the high street? "With interest rates so low," argues Jason Hollands, deputy managing director at independent financial adviser (Ifa) Bestinvest, "those looking for a higher level of yield and better returns will have to move further up the risk spectrum. Before they do this, of course, they should always put aside as much cash as they are comfortable with."

With-profits bonds


With-profits bonds are one way of getting exposure to the stockmarket while minimising the risks. Not only are they made up of a spread of investments, including equities, fixed interest products such as gilts (government bonds), property and cash, they also hold money back in the good years in order to "smooth" returns over the term of the investment.

Another redeeming feature of the with-profits bond are the bonuses: the annual bonus which, once paid, cannot be taken away, and the "terminal", or final bonus, which will depend on several factors including performance and actuarial calculations. However, the choice of bond is important as certain bonds will have a higher weighting in equities and will therefore be riskier.

"Historically", says Mr Hollands "with-profits bonds have had much higher yields than cash - around 10% on average. However, investors need to have a view of at least five years, as they can comprise heavy early exit penalties. But despite the bad press they've received - and they certainly do need to become more transparent - there are still attractions to this type of product."

In terms of tax, with-profits bonds are good news for basic and higher rate taxpayers as returns are taxed at source, although the latter do, admittedly, have to pay the difference between the higher and the lower rate.

Zeros


Another option for investors, in particular those looking to draw on or free up a prearranged amount of capital at a set time in the future (for example, for school fees, that holiday of a lifetime or a daughter's wedding), are zero dividend preference shares. "Zeros" are the most secure share category in a split capital investment trust, or "split", and are always paid out first on the wind up of a trust. They're also extremely tax-efficient, particularly for higher rate taxpayers, because returns are deemed to be capital gains rather than income.

Until recently, no zero had ever defaulted on its obligation, but following the recent collapse in technology shares, in which many splits were heavily invested and often highly geared (they had, in other words, borrowed to benefit more from the soaring tech market), a handful have failed to deliver in full. But this shouldn't put investors off.

"If you're a cautious investor and you do opt for a zero," says Mr Hollands, "just make sure you avoid those with high borrowings and cross-holdings with other split capital investment trusts." If you abide by this rule, he argues, you should be able to sleep at night.

Corporate bond funds


A third option for people looking to break out of cash but who are not quite prepared to enter the volatile world of equity investment are corporate bond funds. A corporate bond is quite simply an IOU from a company promising to return loaned capital at a set time in the future and, in the interim, to pay a fixed rate of interest.

But it's important to remember that such funds can vary substantially in terms of risk. Some, for example, will be made up of relatively safe "investment grade" bonds while others will be heavily weighted in riskier, or "non-investment grade" bonds, which are more likely to default.

However, the increased risk involved with funds with a non-investment grade bias means that the yields can be higher. Rather than a 5% or 6% annual return, if all goes to plan investors could be looking at a return of around 8% or 9%. The icing on the cake is that corporate bond funds can be wrapped in an individual savings account (Isa) to maximise their tax efficiency.