These bonds are offered by life insurance companies and look to provide a rising income as well as capital growth. Typically they offer an annual income of around 5 per cent tax-free and this is paid quarterly. Investors can also withdraw capital if they need to.
The investor's money (based on a minimum of pounds 5,000) is invested in the life company's distribution fund which invests in equities, fixed-interest and index-linked stock, property and cash. The amount invested in each asset varies, but normally between 40 to 60 per cent will be in equities.
This mixture of assets provides security as well as the potential for good growth, says Roddy Kohn, principal of Bristol-based independent financial advisers Kohn Cougar: "Distribution bonds have weathered the recent volatility in the stockmarket particularly well. Those managers who had their investment in blue chip shares coupled with the balance in gilts and fixed interest stock have seen their fund value rise in the falling market," he says. The income paid on a distribution bond comes from the fixed-interest stock, any property rental income, plus the dividends earned on the equities in the fund. All this income is distributed, unlike a with-profits fund where some income may be kept back to boost payouts in later years when the fund does not do so well.
Distribution bonds are much more sensitive to the performance of the stockmarket than with-profits bonds, which means they are generally regarded as higher risk but also offer potentially better rewards.
However, distribution bonds are still relatively low-risk and are aimed at the cautious investor who wants some security but also exposure to the equity market. These bonds tend to attract older people looking for a low risk income yielding investment. Younger people tend to want more of their money invested in the stockmarket where, long term, they can expect higher rewards.
Distribution bonds are not suitable for non-taxpayers as income is paid net of basic-rate tax.
When choosing a bond look at the following criteria:
Make-up of the fund. This tells you how much income to expect and the risk profile of the fund, says Patrick Connolly, investment manager at independent financial advisers Chartwell Investment Management. "The key factor is how much of the fund is invested in equities. The more there is the higher the risk."
Past performance. Look for a fund which has provided consistent levels of income and capital growth during both good and bad stockmarket periods.
Charges. Funds typically have an initial charge of 5 per cent and an annual fee of 1 per cent. Any amount above this needs to be justified and if there is no initial charge check the annual charge and exit penalties carefully.
Mr Connolly currently likes the distribution bonds offered by Clerical Medical, Sun Life, Royal Heritage, Allied Dunbar and M&G. While Mr Kohn also likes those offered by Scottish Equitable and Friends Provident.
These bonds are not for all income seekers. Investors may like the idea of the asset mixture, but may want more income or be prepared to take more risk, points out Mr Kohn.
So instead of buying off-the-peg, investors may be better off constructing a portfolio of their own along the same lines as a distribution bond, but more closely tailored to their own particular circumstances, says Mr Kohn.
Chartwell Investment Management has produced a free guide to Distribution Bonds which is available by calling 01225-446556