These conservatively managed investment bonds, issued by the leading insurance companies, invest mainly in a mixture of gilts, UK and international shares, and commercial property.
They are aimed at people with money in a building society who are wary of direct equity investment because of stock-market volatility, and have proved an attractive, relatively "safe" investment in the past.
But 1994 seems to have proved that even distribution bonds can be hit by falling stock markets.
Distribution funds work by keeping income separate from capital. Income is distributed as a dividend, which is declared regularly, normally every three or six months. The dividend purchases units in a separate cash fund from which income payments can be made to investors. So if the stock market falls the income will be largely protected from any downturn of capital value.
Building society rates have fallen substantially in recent years and distribution funds have generally produced a higher initial net income for basic-rate and higher-rate taxpayers.
There are more than 20 distribution funds and most of them are producing an income of between 4 and 7 per cent, which is free of capital gains and income tax at the basic rate.
Income payments may have been maintained but what has been happening to the underlying value of the funds? Certainly, investors in most of the distribution funds on the market will have seen their investment hard hit last year. Michael Aaron, financial planning manager at independent financial adviser David Aaron Partnership, says: "If you have held a distribution bond over the past year you will have seen a big loss. That's because almost every area they invest in, particularly equities and gilts, have been hit. You were also getting poor returns from cash over that period."
The pure capital performance of these funds last year does not look encouraging. The underlying value of every distribution fund has fallen by more than 14 per cent in a year.
Friends Provident's Income Distribution Fund fell by 23.5 per cent over 12 months to the beginning of January this year. Skandia's Distribution Fund was down nearly 21 per cent, and Save & Prosper's Managed Income Distribution Bond fell more than 19 per cent.
Even if the income had been reinvested last year the situation would not have been much better. Not one fund would have shown a positive result. Friends Provident's fund would still be down 21 per cent, Skandia's 15.5 and Save & Prosper's 15.
The 120,000 people who are invested in the largest and longest-established distribution fund, managed by Sun Life, will have seen the value of their investment fall by nearly 13 per cent.
Nick Wardrop, Allied Dunbar's investment marketing consultant, said: "A lot of funds have certainly been suffering. The UK stock market crashed last February with the market falling 16 per cent in a few months. That had a significant effect on all UK equity-based funds."
But Allied Dunbar's £175m Distribution Bond had fared better than most since its launch in October 1993. Mr Wardrop said the fund had grown by nearly 4 per cent when the average had been nearer 0.5 per cent over the same period. "We have a good chunk of property in the fund, which has stood us in good stead," he said. "We managed to capture the up-swing in the property market 12 months ago, which has boosted our fund's overall performance."
How the fund is divided up in investment terms is an important consideration and provides a clear guide to the risk of the fund. Fund managers have adopted very different investment strategies. The classic portfolio would be, say, 30 per cent in UK equities, 30 per cent in fixed interest securities, 10 per cent in overseas equities, 10 per cent in property, 10 per cent in cash and 10 per cent in a mixture of other assets.
But there are enormous variations among the different companies. The Sun Life product has 36 per cent invested in index-linked gilts, while most companies have no such exposure at all. Friends Provident's fund has 85 per cent in UK equity unit trusts while the Norwich Union Cautious Fund has no equity exposure whatsoever.
Mr Aaron says higher-risk distribution funds will have more than 55 per cent invested in equities. Medium-risk funds are those with 30 to 55 per cent in UK shares, and lower-risk funds will be invested in gilts, property and cash, with less than 30 per cent in equities.
He says: "The other thing to remember is that you should be investing for the longer term. You should hold on to the fund for at least five years to get benefit from it, and then you will find it provides the potential for good capital growth and reasonable income, which should rise over the years."
The original investors in the £l.8bn Sun Life Distribution Fund have seen their income double in 15 years, while the value of their initial capital has nearly trebled. Ron Bewsey, from Bexley, Kent, invested £40,000 in the Sun Life Distribution Fund two and a half years ago when he took early retirement from a construction company. "I hunted around for a suitable place to invest my money," he said. "Not being a gambler and having weighed up the pros and cons of different products, I decided I would go for the bond."
Mr Bewsey, 58, said he wanted both income and capital growth. "Fortunately, I haven't had to take much income out of the fund, but it's good to know it's there if I need it," he said. "The first year, the fund did exceedingly well. It's gone down a bit in the past year but I'm keeping a close eye on it."
q The David Aaron Partnership has produced a 22-page guide to distribution bonds, which is free to all `Independent on Sunday' readers. Contact: 0908 281544.Reuse content