Guarantees are not quite the best of both worlds: Vincent Duggleby builds some DIY equity schemes to challenge the building societies

INVESTORS concerned about failing interest rates are being wooed by building societies with bonds linked to the stock market that appear to offer the best of both worlds: growth if the market rises, security of capital if it falls.

The guarantee is that investors will at the very least get their money back at the end of five years, and some companies have introduced 'lock-in' features that rely on sophisticated use of futures and options. This ensures that growth in one year (or one quarter) will not be sacrificed if there is a sudden fall in the FT-SE 100 share index, to which most of the bonds are linked.

'The principle is very simple,' said David Wheildon of Pall Mall Money Management. 'Part of the money goes on to deposit to produce the fixed return, the other part is used to play the market but it is wrapped up in a pretty parcel to make it look more clever than it really is.'

Peter Hargreaves of Hargreaves Lansdown pointed out that it might not be possible for investors to get their money back in less than the usual five-year term, and there was no income paid in the meantime. He is convinced that an equally good return can be obtained by a mixture of gilts, growth bonds or zeros for the guaranteed part, combined with income or capital shares from an investment trust.

Kean Seager of Whitechurch Securities also favours the do-it-yourself approach, which can take advantage of the annual tax-free allowance for capital gains (pounds 5,800 in 1992-93).

'You have to remember that the return from the building society bonds is usually quoted gross,' he said, 'although basic rate tax will be deducted from it and higher rate taxpayers may face an additional charge. Tax is a big handicap for the building societies.'

Northern Rock is the latest building society to offer an equity bond that guarantees a 16 per cent gross return over five years or the percentage rise in the FT-SE 100, whichever is greater. At the very least an investor would receive a net return of 11.25 per cent, equivalent to 2.38 per cent per annum.

The offer period runs from 1 March to 8 April and the bond will mature in April 1998. There is also a 'lock-in', which means that if the index rises by 60 per cent at any stage during the five-year term, that becomes the new guaranteed minimum return.

Adam Applegarth, Northern Rock's assistant general manager, agreed that societies were responding to the competition from unit trusts and personal equity plans. He said the bond should appeal to those prepared to take some risk in sacrificing income, but they were not being asked to gamble with their capital.

Alliance and Leicester does allow early redemption but with reduced guarantees. The National and Provincial and Yorkshire offers have just closed but they expect to launch further bonds along similar lines in the near future.

Independent advisers believe that more flexibility and better rewards can be achieved by investors who prefer to put together their own mix of guaranteed and secure products. One straightforward combination would be to split an investment of pounds 10,000 between National Savings and a unit trust tracker fund.

The current 40th issue certificates yield 5.75 per cent tax-free over five years and the Capital Bond 5.0 per cent (after basic tax), which means that pounds 7,550 would need to be invested to guarantee the pounds 10,000 return of capital. This leaves pounds 2,450 to go into the tracker or any other type of trust, so with no growth over five years, and excluding income, the return would still be above 20 per cent.

If the index rose by, say, 40 per cent over the five years, pounds 10,000 in Northern Rock would grow to pounds 13,000 (after tax) but the DIY plan would be worth about pounds 13,250. At 48 per cent the plans would be level: thereafter the society would move ahead.

Obviously the larger the the equity portion the bigger the potential gain if the market does rise appreciably. Peter Hargreaves pointed out that the risk can be increased or decreased in line with the investor's own preference.

----------------------------------------------------------------- THE SOCIETIES ----------------------------------------------------------------- Society Min Deadline G'tee FT-SE Lock-in Early Invest Redem'n pounds % % Alliance & Leics 1,000 19 March 120 100 No Yes Bristol & West 1,000 17 March 100 110 No No Northern Rock 2,500 8 April 115 100 Yes No Yorkshire 5,000 closed 125 100 No No National & Prov 1,000 closed 100 133 No No ----------------------------------------------------------------- THE ADVISERS ----------------------------------------------------------------- DIY pounds 10,000 invested (less expenses) over five years ----------------------------------------------------------------- Pall Mall (David Wheildon) Henderson Eurotrust zeros (redemption pounds 10,000) pounds 6,779 Schroder UK Equity PEP pounds 3,034 Total (no equity growth) 130% ----------------------------------------------------------------- Hargreaves Lansdown (Peter Hargreaves) TR Technology zeros (redemption pounds 11,150) pounds 7,511 General Consolidated Inv Trust Capital pounds 2,439 Total (no equity growth) 135% ----------------------------------------------------------------- Whitechurch Securities (Ken Seager) Drayton Blue chip zeros (redemption pounds 10,000) pounds 6,498 Aetna Smaller Companies PEP pounds 3,292 Total (no equity growth) 133% -----------------------------------------------------------------