So what is a with-profits bond? It is an investment that pays you an income and also grows through annual bonuses. For 1999 these are likely to be between 6 and 6.5 per cent. Most bonds also pay you some sort of bonus when you cash in the policy, or on death. As an example, Scottish Equitable is currently paying a terminal bonus of 2.5 per cent. (You usually have to hold your investment for at least five years to be eligible for this.)
Because the underlying investment fund is taxed, there is no extra tax to pay - even if you are a higher rate taxpayer - as long as you only take an income of up to 5 per cent (of your original investment) each year.
With-profits bonds are run by the giant life insurance companies. They are sold by life company salesmen and by independent financial advisers. The main disadvantage until now has been that these salespeople usually take 6.5 per cent of your investment in commission for advising you and selling the bond. If you can make your own decision about which bond to buy, you can save up to 5 per cent of this initial charge by buying it through a discount broker.
All money invested in with-profits bonds is put into the insurer's giant with-profits fund (the same fund that backs an investment in an endowment policy). The fund is diversified among a range of income and growth investments including shares, fixed interest securities (such as government bonds) and property. This lets you spread the risk around while getting the boost that only equity investment can provide.
Patrick Connolly at Chartwell Investment Management in Bath, an expert on with-profits bonds, suggests they offer an excellent opportunity for cautious income-seekers.
"If you are willing to lock up your money for five years or more, you should get a better return than you would from other secure investments," he says.
Falling interest rates do affect with-profits funds. Life companies decide on their bonus rates for 1999 this month, and those that have already been announced are down on last year. Scottish Widows, for example, has dropped to 5 per cent from 6.25 per cent. Despite this, Mr Connolly says he expects sales of with-profits bonds to remain buoyant.
"Most bonuses have reduced slightly but you have to weigh that up against what you can get elsewhere. Other interest rates are all coming down," he says.
A possible future disadvantage of with-profits bonds is that if the stock market and interest rates both crash, then a life insurer can act to try to prevent its customers from withdrawing their cash from a badly performing with-profits fund. They can impose an MVA, standing for market value adjustment. The idea is that an MVA ensures a fair spread of assets between those who are leaving the fund and those who stay invested, and it is imposed when the underlying assets are worth less than the quoted value of your units. The MVA problem is something to bear in mind, but it does not usually affect regular withdrawals and it would not be imposed when an investor dies.
Do not consider a with-profits bond if there is a chance that you will have to cash it in within five years. Most insurers have a sliding scale of penalties for early leavers, ranging from 8 per cent downwards. If you cashed in your Prudential with-profits bond after two years, you would pay a penalty of 4 per cent of your investment.
If you want to invest in a with-profits bond, select your life company carefully. This is one area where bigger is better, so look at the financial strength rating of any company in which you plan to invest.
"The stronger life companies have more investment in equities and have reserves to back it up," says Mr Connolly. Some of the smaller life firms have to have more assets tied up in safer fixed-interest investments to be sure of meeting any liabilities in the case of a stock market crash. Legal & General, Prudential, Pearl, Scottish Equitable and Scottish Widows are AAA rated. They have huge asset reserves. Several other big names are AA rated including CGU and Norwich Union.
Every bond differs slightly in terms of the mix of investments in its with-profit fund, and you should read up about this before you buy. Axa Sun Life, Prudential and Scottish Equitable all have more than 75 per cent of their with-profits fund invested in equities, while NPI has under half of its investors' money in shares.
Also bear in mind that mutual life insurers, which are owned by their members, may well be taken over in future. In this case the with-profits bondholders will get cash or share windfalls in the same way as those who are members of building societies which convert into banks.
IFAs at the David Aaron Partnership tip Scottish Provident and Friends Provident as possible targets for takeover. Other mutual life insurers offering with-profits bonds include Equitable Life and Scottish Widows.
Don't select your choice of bond simply on its mutual status, but Scottish Widows combines financial strength, past performance and mutuality. It is second in Chartwell's top 10 tips for the best buys in 1999 (see box). The number one, in terms of past performance and future potential, is Prudential.
Finally, send for guides to with-profits bonds. These contain lots of useful performance and financial strength information and they are produced by firms which also offer discounted dealing charges.
You should be able to save almost all of the commission and initial charge on these bonds by buying through one of these discount brokers: Chartwell, 01225 446556; Hargreaves Lansdown, 0117 900 9000; and Financial Discounts Direct, 0500 498477.
Other discount brokers dealing in with profits bonds are: Elson Associates, 0181-308 9888; and TQ Direct Choice, 08000 561836.
the top 10
Leading with-profit bonds
These are Chartwell's recommendations, based on past performance and financial strength. All have a minimum investment of pounds 5,000 except where stated.
1. Prudential (pounds 6,000)
2. Scottish Widows
3. Scottish Equitable
4. CGU Life
5. Royal & SunAlliance
6. Scottish Mutual
7. Scottish Provident (pounds 10,000)
8. Clerical Medical
9. Friends Provident (pounds 3,000)
10. Eagle Star