Unlike with profits bonds where the annual bonus, the profit element, is decided by a professional actuary based on the performance of the fund over the past year, the price of the units in a distribution bond can move on a daily basis in line with the performance of the underlying securities. These types of bonds are less volatile than other forms of managed investments.
Sun Life was the first to issue distribution bonds almost 20 years ago. "We looked at the needs of investors," says Mark Stirrup, of Sun Life. "They told us that they wanted an investment that would pay a little more than they could get with a building society, an income that would increase over time and one that offered the prospect of capital growth."
The guaranteed bonds available at the time offered either a fixed income or a fixed rate of capital growth. "While there were unit trusts, these were pure equity investments," adds Stirrup. "We wanted to offer something less volatile. When we launched the Sun Life Distribution Fund, there had never been anything like it."
Sun Life, which now manages assets of pounds 2.78bn, had the field to itself for some 15 years before other life companies began to offer similar funds. Today, there are nearly 20 different distribution bonds available. Sun Life's bond fund is the largest, followed by Legal & General's and then the Prudential's bond.
The bonds invest in a similar way to the main life funds. In the case of Sun Life, it is 40 per cent invested in gilts and bonds, 40 per cent in equities and 20 per cent in convertibles. Quite a large proportion of the gilts are index-linked, for their safety-first, guaranteed return.
Over the past five years, anyone who invested pounds 10,000 in this bond would have enjoyed an income of pounds 6,952 and their capital would now be worth just under pounds 16,000. Compare this with a higher rate building society account, where it would have generated an income of around pounds 6,160 over the period, but the capital would not have grown at all.
With Legal & General, the pounds 500m distribution bond fund has 82.5 per cent of its assets split between equities and fixed interest stock, another 12.5 per cent invest in property, while the rest is held in cash. Since its launch nearly five years ago, it has increased the income per unit every year from 2.5p in its first year to 3.08p last December. Since its launch, the price of it units has risen nearly 29 per cent.
Investors can cash in up to 5 per cent of their holding in a distribution bond each year, with payments on a monthly, quarterly, half-yearly or annual basis. Just like with profits bonds, this is treated as a return of capital.
"For higher rate taxpayers, distribution bonds can be a useful in retirement planning," says Michael Hayden of Legal & General. "Most probably, they will become basic rate taxpayers after they retire. If the bonds are cashed in then, they will have no tax liability."
Like most unit trusts, distribution bonds generally have a 5 per cent spread between the buying and selling price of units, out of which commission is paid to financial advisers, and an annual management charge of around 1 per cent. They will also give the investor minimal life cover of 101 per cent of the original investment.
The minimum investment in a distribution bond is usually around pounds 5,000. For larger amounts, investors will find that they will get a bigger allocation of units. Legal & General, for example, will invest 104 per cent for anyone prepared to place pounds 30,000 or more into its own distribution bond.
Not to be outdone, a number of unit trust management groups, including AXA Sun Life, Barclays, Framlington M&G, Newton, Prudential and Save & Prosper also offer funds that operate in a similar way.
Usually with a minimum investment of pounds 500 or pounds 1,000, they invest in a mix of fixed interest and equities, "looking to give a total return to investors; that is a rising income stream and capital growth," says Stirrup.
These unit trusts can be put into a PEP. Up until 5 April, all the income and any gains will be tax free. After then, when PEPs come to an end, while any growth will be free of capital gains tax, any dividends paid on the equity element of the fund will be liable to the 10 per cent rate of advanced corporation tax, which rises to 20 per cent in 2004.
"Distribution funds could become the key product for the new millennium," says Roddy Kohn of Kohn Cougar, a leading independent financial adviser. "The combination of equities, fixed interest and gilts will bring positive benefits in an era of low inflation and low interest rates so long as the fund manager picks the right kind of stocks."
While corporate bonds are the answer for those investors who want to achieve an immediate high level of income, distribution bonds and their unit trust equivalents will suit those who don't want the risks of a pure equity investment, but who would like the prospect of a steadily rising income and capital growth.