Investing for Income: Foolproof security - with a catch

MOST of the current crop of fixed-interest investments or those offering a high income involve some sort of risk to your capital. But there is one product that does offer a guaranteed income for a fixed term, with a full return of capital at the end of the investment period.

Guaranteed-income bonds are sold by a handful of companies. Names to look out for include AIG Life, GE Financial Assurance, Pinnacle Assurance, Scottish Friendly, Wesleyan, Woolwich Life, Lloyds TSB Life and Abbey Life. Not all are familiar names but they are authorised insurers, so you will have full protection for your money.

Most bonds have a term of one, five or 10 years. The minimum investment starts at pounds 2,000 and the more you invest, the better the interest rate.

The main problem with guaranteed-income bonds is that the return seems relatively low, even for large sums. For pounds 10,000, Pinnacle will pay 4.8 per cent for one year and 4.4 per cent a year for five years, while Countrywide Assured will pay 4.4 per cent a year for three years if you invest at least pounds 20,000. If you only have pounds 2,000 to invest, the best you can hope for is about 4.2 per cent.

The insurers invest the money in fixed interest and gilts (government bonds) to produce secure returns. The yields that they offer have fallen as interest rates have declined.

These returns are what standard rate taxpayers receive, while higher rate taxpayers will have to pay an extra 20 per cent tax. Guaranteed income bonds are not much good for non-taxpayers as they will not be able to reclaim any tax. They would be better off looking at conventional deposit accounts where the tax can be reclaimed.

There are plenty of alternative investments. Alliance & Leicester, for example, has recently launched a one-year bond that pays 5.4 per cent gross, so you will have to pay tax on this.

Deposit accounts offer potentially better rates of return, although these will drop as interest rates fall - and remember you have to take off 20 per cent or 40 per cent tax. Real returns are already barely ahead of inflation. The new-style telephone deposit accounts from the likes of Standard Life are currently paying 6.10 per cent gross.

There are better rates on offer from high-interest bonds linked to stock market performance. You get an income plus your capital back at the end. But on many bonds, the small print will reveal a potential loss of capital if there are any falls over the long term in the stock market indices to which the investment is linked. These bonds soared in popularity a few years ago. But the number of high income bonds on offer has declined dramatically since last summer. The volatile conditions in the equity markets meant the price of derivatives yo-yoed and made these deals too expensive.

Scottish Life, through its international subsidiary, has one of the few high income bonds currently on offer. For a minimum investment of pounds 7,500, the bond offers either 9 per cent a year or 2.125 per cent a quarter, tax free to basic rate taxpayers, over a five-and-a-half- year investment period.

If you are looking for an alternative way to protect your capital and take an income, a new PEP from HSBC offers just that. The Capital Protected Income PEP is listed on the Dublin stock exchange, which means that (providing you haven't already used your PEP allowance this year) you can put up to pounds 9,000 into the PEP - pounds 6,000 through your general PEP allowance and pounds 3,000 through a single company PEP. Money has to be invested for five years, and you will receive a tax-free income of about 7.25 per cent a year. After five years the initial investment is returned.

Contacts: Abbey Life, 01202 292373; AIG Life, 0700 244 5433; Countrywide Assured, 0800 838020; GE Financial Assurance, 0181-380 3388; Lloyds TSB Life, 01634 834000; Pinnacle Assurance, 0181-207 9007; Scottish Friendly, 0141-275 5000; Wesleyan, 0800 228855; Woolwich Life, 01737 765505; Scottish Life, 0131-456 7777; HSBC, 0800 289505.

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