When a storm has been raging over shares, is the time really right to buy into bonds?

Guaranteed equity bonds are supposed to cushion cautious savers against the worst ravages of the stock markets. But, finds Paula Hawkins, protection can come at a high price
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The Independent Online

When stock markets are as volatile as they have been recently, it is natural for investors to start casting around for places of refuge. This is where guaranteed equity bonds (GEBs) are supposed to help. According to the marketing blurb, GEBs offer the safety of a deposit account combined with the growth potential of a stock market investment.

They work by splitting investor cash between an equity fund and a savings account, or some other vehicle such as a derivative. If the market falls, the original investment is "guaranteed" by the performance of the savings vehicle or derivative.

There are dozens of GEBs on the market, the most recent launch being Egg's five-year bond, which pays out 125 per cent of the growth of the FTSE 100 over five years. So if that index rises by 50 per cent between now and 2012, an investor in Egg's GEB will receive a return of 62.5 per cent. If the FTSE 100 falls, the original deposit will be handed back, although the investor will not see any interest.

Jonathan Gains at Egg says the bond is aimed at cautious savers "seeking investments that mitigate the risk of investing directly in stocks and shares".

But independent financial advisers (IFAs) say GEBs are a long way from being the perfect solution for risk-averse investors.

Patrick Connolly from IFA firm Towry Law is stinging about the bonds and how they are marketed: "Product providers often launch GEBs after a period of stock market volatility – not because this is the best time for somebody to buy them, but because they are usually easier to sell."

Mr Connolly believes that investors often show an interest in GEBs at entirely the wrong time. "They consider these products after markets have fallen and they are feeling more nervous. A more logical time would be after markets have performed well, so that investors can, in effect, bank their gains."

There are plenty of downsides to GEBs. First, they are inflexible: money must stay invested for the full term. Second, they are not without risk. If the underlying indices fall in value then investors won't make any money. They will get back the money they put down in the first place, but in the time it has been stuck inside the GEB, its value will have been eroded by inflation.

In addition – and this is a critical failing, according to IFAs – GEBs do not pay dividends, offering just capital growth instead.

"There is a price to be paid for capital protection and the most important one is the lack of dividends," says Anna Bowes at IFA AWD Chase de Vere. "This can be expensive, because dividends form a significant part of the return on a stock market investment.

"The upside is that you can sleep at nights knowing your capital is safe."

But for Mr Connolly, GEBs are simply a bad idea. "We have not yet found a product where the price you pay for the guarantee is worth it," he says.

"That price can be: not getting full exposure to underlying gains; not benefiting from any dividends that would normally accrue; tax inefficiency; lack of flexibility – or any combination of these."

Cautious investors, he advises, should instead consider savings accounts, fixed-interest securities or commercial property.

If you are still tempted by GEBs, you need to con-sider a number of factors when choosing between products. First, check which stock market index is being tracked by a bond. Most GEBs follow Britain's benchmark FTSE, but some look further afield. Abbey, for example, offers GEBs linked to the US Standard & Poor's 500 index, to the Nikkei 225 and to Hong Kong's Hang Seng index.

Bank of Ireland, meanwhile, offers a global growth bond that is connected to a number of indices across the world.

Some bonds are not even linked to stock markets. Newcastle building society's property bond offers investors up to 120 per cent of the growth of the Halifax House Price Index over a five-year period.

In addition, you need to look at something called the "participation rate" – the extent to which your investment benefits from the performance of the index. These rates vary considerably, with some bonds offering 100 per cent of an index's growth, some as much as 130 or 140 per cent. Others may offer a percentage of the average growth over the entire term of the bond, rather than of the absolute growth.

Finally, you should consider the bond's "averaging". Most GEBs will have some element of this, often over the last year of the bond. What it means is that the final outcome is determined by recording the monthly closing level of the index over each of the final 12 months of the bond's life and averaging this figure out. This can work in investors' favour, since it protects them in the event of a sudden downward movement of the underlying index towards the end of the bond term.

However, it can also work against investors. Should the index rise rapidly in the last year of the investment, they will not benefit fully from the increased growth.

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