Even cautious investors could hope for happier returns from Ernie, 52

Even cautious investors could hope for happier returns from Ernie, 52

Customers have piled money into National Savings and Investments (NS&I) premium bonds in recent months, attracted by the fact that they offer cautious investors a guaranteed home for their capital with the potential for tax-free winnings.

However, investing in premium bonds is not without its drawbacks. At the moment, the premium bond prize fund rate is equivalent to an interest rate of about 1% a year, which is much lower than the rates of interest you can find on many savings accounts.

In March, NS&I removed one of the two £1m jackpots that were available each month, claiming it would be distributed as a wider mix of tax-free prizes, and introduced a new £25 prize. Previously the smallest prize you could win was £50.

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Andrew Neligan, of independent financial advisers Informed Choice, says: "The fact that premium bond investments are backed by HM Treasury offers individuals the security of capital but in effect they are playing a lottery.

"If you are lucky enough to win, then a cheque in the post can make a nice, tax-free surprise, particularly if it is £1m. But given the chances of winning, and that the lowest prize is now £25, the rate of return over the medium to long term is unlikely to be above inflation."

The odds of each £1 premium bond winning any prize are 36,000-1, so with average luck, an investor with the maximum £30,000 invested could win 10 tax-free prizes a year.

However, they could also win nothing at all, so many experts believe savers would be better off putting their money into a high-interest savings account instead.

Philip Pearson, of Southampton-based independent financial advisers P&P Invest, says: "Barclays Bank's Golden Isa, for example, which offers instant access, currently pays 3.55% gross interest a year - which is considerably higher than the average return from premium bonds. This rate includes a 1% bonus payment for the first 12 months."

If you have already used your cash Isa allowance this tax year, you could consider a high-interest paying savings account as an alternative to premium bonds.

Neligan suggests Investec's High 5 account: "This promises to pay the average of the top five interest rates, so, while you will never have the highest rate, you will not buy into the top rate only to see it fall down the best buy tables," he explains. "The account is available to savers with at least £25,000 in savings."

For those with smaller balances, Pearson recommends Stroud and Swindon Building Society's Postal Account, which pays 2.25% gross on a minimum deposit of £1,000.