Check small print in bond 'guarantees'

How cautious investors can still come unstuck

INVESTORS disillusioned with the roller-coaster performance of equities are pouring hundreds of millions of pounds each month into a range of guaranteed bonds from insurance companies. The bonds promise savers an annual income, higher than normally available and tax-free at the basic rate, or guaranteed risk-free growth, plus their money back after five or six years.

In many cases, investors also have the option of limited exposure to the FT-SE 100 share index so that if it moves upwards they stand to benefit, at least in part. The attractions of such bonds seem blindingly obvious. So much so that one company, Scottish Widows, has attracted more than pounds 300m into one of its bonds, offering a guaranteed income of 7.4 per cent or 44 per cent capital growth over five years. Less obvious, however, are some of the potential problems these bonds may pose for savers.

Last week another insurer, Eagle Star, decided not to press ahead with the launch of its own guaranteed bond. The company said it believed the Inland Revenue was preparing to tax gains on these bonds for the first time. More worrying, any legislation could be retrospective, since it would take effect when a gain was realised at maturity. The key to the investment decision is finding out exactly what is meant by a "guarantee", particularly where future taxation is concerned.

Many companies offering such bonds, including GA Life, Scottish Widows, Zurich Life, AIG Life and Winterthur, all state that this is subject to their understanding of current tax laws, which may change. To date only Scottish Widows has publicly stated that no matter what future changes, it intends to abide by its promise to savers, even if it has to pay tax on their behalf.

Concern on this issue is likely to lead the Personal Investment Authority, the personal finance watchdog, to issue further guidance to its members on how they should make more explicit the small print in these products to potential investors.

Amanda Davidson, a partner at the independent London advice firm Holden Meehan, said: "I am always suspicious when I see the word 'guarantee'. It rings alarm bells. You have to be careful that these guarantees are worth the paper they are written on.

"Bonds like this are likely to be attractive to elderly people looking for a cautious investment. But it is precisely vulnerable people who need to be careful.

"My advice is always to ask myself: 'What is the worst-case scenario with a bond like this?' If I am prepared to accept that scenario then I invest. If not, I look for something else."

Her views were backed by Roddy Kohn, a financial adviser at Kohn Cougar in Bristol. He said: "Quite a few people come to my office asking about these bonds. But if they go for investments without understanding what they mean, they are exposing themselves to big disappointments." For example, Zurich Life's bond offers up to 75 per cent growth, paid net of basic rate tax, over 5 years, or 11 per cent income per year. But the small print says the original capital will be returned only if the FT-SE 100 grows by 1.99 per cent compound growth each year over the investment period. In addition, the S & P 500 share index, the equivalent index in the United States, must also grow by the same amount.

If the FT-SE 100 were to grow by an average of 5 per cent a year but the S & P 500 only rose by 1.98 per cent a year, the capital returned would be less. Of course, as Zurich Life claims, both indexes have seen average annual growth of 9 per cent for every five-year period since 1984. Other companies base their offers only on the Footsie's growth.

Mr Kohn said: "Investors also need to look at how these average growth figures are calculated. Zurich Life measures them as the average over the full five-year period. Winterthur's is based on the average in years three, four, five, and six.

"If shares rocket in the first two years but stay flat in the later ones, fund growth will be affected even though you will get all your money back."

Another area to consider is that the time-frame of these investments may well take in a change of government in Britain. A generous interest rate today may look mean in five years - or vice versa. Mr Kohn advised investors to look out for the exposure their bonds have to the markets. If, for example, 20 per cent of their funds is linked to the FT-SE 100 and it grows by 50 per cent, the total increase they will receive on their investment is 10 per cent.

"Ironically, I am not opposed to these bonds," he said. "They show that the industry is trying to develop what investors want - security of capital, the prospect of capital growth, and high income. But I do feel that savers should do their homework carefully and not just look at a headline rate. Otherwise they risk making serious mistakes."

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