Money: Investing for income - A guarantee you can't rely on

  • @simonnread
"INVESTORS chasing a guaranteed high income may be suckered into risking their capital," warns Chislehurst-based independent financial adviser Brian Dennehy. "Some of the so-called guaranteed high-income bonds on offer could be another financial services scandal waiting to happen."

He says consumers are confused by the range of guaranteed bonds being offered, where the actual guarantees are not always what they might seem. The culprits are the high-income bonds and guaranteed equity bonds where only the income is guaranteed. The saver's capital - the cash invested - can be very much at risk.

Investors attracted by the idea of a guarantee are likely to be shocked if they discover that their savings could have shrunk by the end of the bond's term.

It is important to draw a distinction between traditional guaranteed income bonds (GIBs) and the more recent stock market-linked bonds. A guaranteed income bond is an investment for a fixed period with a guaranteed return. Investors can choose to draw the income monthly, or let it accumulate and take it all as a lump sum at the end of the agreed term, which can be anything from one to five years. At the end of the period, your original money is also guaranteed.

There are a small number of companies which compete in the GIBs market. Typically they offer better returns than the normal building society deposit rates for taxpayers. Mostly insurance companies, they offer GIBs for a limited period.

A sample of recent rates available includes 5 per cent over three years for pounds 10,000 from Black Horse Financial Services, 6.05 per cent over one year for pounds 3,000 from Pinnacle Insurance, and 5.6 per cent over five years for pounds 5,000 from Woolwich Life. Importantly, all rates quoted are net of basic-rate tax, so they should not be compared directly with the gross rates quoted on most deposit accounts.

"Guaranteed income bonds are simple, straightforward products and make sense for many taxpayers, and more so for higher-rate taxpayers," says Mr Dennehy. "High-income bonds are a completely different product, though the public seems to have a problem in making this distinction, and that concerns me and many others in the financial services industry."

Essentially, a typical high-income bond will offer guaranteed income of around 10 per cent a year for an investment period of five years. What is often not made clear is that the return of capital at the end of five years depends on the performance of certain stock market indices, which may not even be UK ones. If an index falls over the five-year term, you will not get back all your capital, and may only receive just 50 per cent.

"Some say the odds of this happening are very small," says Mr Dennehy. "More objective analysts have put the odds at one in five. But my gut feeling is that the odds are worse than that. Despite representations to the regulators, I don't believe the marketing material on these products makes clear that they carry any risk and just what the extent of these risks are to capital. That's why I feel there's a potential scandal in the making."

The problem with these stock market-linked bonds is the perceived misuse of the word "guaranteed". With high-income bonds, what is actually generally guaranteed is the income. This will be paid out at the expense of capital if the underlying stock market index fails to perform as anticipated. So if a bond offered a 10 per cent income and the FT-SE 100 index, for instance, only rose by 4 per cent, the outstanding amount needed to meet the monthly income payment would in effect be withdrawn from your original investment. Consistent underperformance by the index would lead to more demands on your capital until it was severely eroded. The result would then be that you achieved the desired high income, but only got back part of your original investment at the end of the bond's life.

The high-income bond providers point out, in their defence, that adding together the capital returned to you and the income paid out will mean that you won't have actually lost out in absolute cash terms. But following this argument means you may as well keep the cash in your pocket and draw on it as needed - the end result will be exactly the same.

Don't let these criticisms put you off traditional guaranteed bonds if it's income you are after. For the best GIB rates, see our Best Savings Rates table on page 12.