FOOL'S EYE VIEW
Premium Bonds: The Price of Safety

By David Kuo (TMFDragon)
April 25, 2002

Whenever you gamble you should be prepared to lose or more precisely you should expect to lose. By this I mean punters should expect a negative return over the long term as a result of their gaming pursuits. Contrast this with, say, the activity of the long-term stock market investor. The expectation in this instance is positive, which means that that long-term investor can expect to be better off as a result of being in the market.

There are no known games of chance that favour the punter over the operator. But some may argue that Premium Bonds (or Premium Savings Bonds Series B to give them their rightful nomenclature) are the exception. With Premium Bonds, there appears to be no apparent risk to participants because the stake is fully refundable. But can this really be true? Have the rulebooks over games of chance been re-written? Is there really a game of chance out there that allows gamblers to win up to £1m without any risk?

Before we answer that question let's take a quick gander at Premium Bonds and see just how they work. Premium Bonds are sold in units of £1 and the minimum purchase is £100. Armed with those 100 bonds, which you can buy through your Post Office, you are eligible to participate in each month's prize draw provided you have held the bonds for at least one calendar month. The pool of prizes is calculated from both the total size of the bond fund and the prevailing interest rate. All prizes are tax free.

There are more prizes at the lower end, starting from £50, and the number of these prizes reduces in a pyramid fashion to just one £100,000 prize and one £1m prize every month. Currently in each month's draw 585,483 prizes are up for grabs. So with 16.7 billion bonds in circulation there is a 1 in 28,500 chance of winning a prize every month for each bond entered into the draw.

These odds appear, at first sight, to be appallingly bad. That is until you consider an individual can hold up to 20,000 bonds at any one time. So blessed with average luck, as the Premium Bonds literature calls it, a bondholder can expect to win 8 times a year. However, because there are proportionately more £50 prizes it far more likely that these wins will be made up of the lower denomination prizes.

In the example quoted in their latest brouchure £50 prizes made up almost 87% of the total monthly prize money. In other words 2.1% of the current quoted yield of 2.4% comes from the £50 prizes. The remaining 0.3% comes from the smaller expectation of getting one of the larger value prizes.

The quoted yield is the total prize fund divided by the total money invested in Premium Bonds. In other words it's what you might expect to win. It varies, usually in line with interest rate movements. For example, only a few months ago it was 3.75%.

The mid-range prizes are £100, £500 and £1,000. In the example a few thousand of these are paid out each month. However, only 52 prizes of more than £1,000 are paid out each month. In other words the chances of winning these are so slim you can virtually dismiss them from the likely range of returns you might get. Or to put this another way the chances of you getting significantly more than the quoted yield are very slim.

It is undeniable that your capital will remain intact but safety also carries a price. Your capital is not protected from the ravages of inflation and the expected return on the investment is worse than you would get from a cash ISA. where interest rates in excess of 4% are available. Additionally your chances of achieving the advertised 2.4% interest rate will depend on surpassing averaging luck. However because the expected value of Premium Bonds is positive they are not as such a gamble. But you are nevertheless sacrificing a higher return that you could get elsewhere. So invest in Premium Bonds only if you feel lucky and don't forget to give the rabbit's foot a good rub at the start of each new month to avoid disappointment.

More: Premium Bonds discussion board