The only way is up

What are the attractions of the escalator bond?

Investors looking for both a guaranteed and rising income over the next years should consider escalator or step-up bonds. These bonds guarantee to pay a set amount each year for a fixed period. The income increases each year and at the end of the term, which is usually three or five years, your capital is returned to you in full.

Escalator bonds provide a regular income, which may be ideal for anyone looking for extra income to top up their pension or provide them with an income during a career break or a return to full-time education.

These bonds are offered by building societies and banks. The minimum investment varies between pounds 500 and pounds 5,000 depending on the provider, and income is paid monthly, half-yearly or annually.

To get the best rates, investors should opt for an annual income. Unlike other bonds, the interest rate you receive is not based on the size of your investment, so you get the same rate of interest whether you invest pounds 5,000 or pounds 50,000.

This can make escalator bonds highly competitive for small investors looking for a guaranteed income from a cash-based deposit.

For example, Portman Building Society requires a minimum investment of just pounds 500 on its five-year escalator bond. The annual income rises from 6 per cent to 6.25 per cent, 6.5 per cent, 7 per cent and finally 9 per cent over the term.

Elsewhere you can start off with an income as low as 4 per cent rising to 12 per cent over the term. (For the latest rates available check the weekend press or Teletext).

Rates change regularly on bonds so when you've discovered one which suits you, telephone the bank or building society to check that the rate is still being offered.

These bonds offer investors peace of mind as you know exactly how much interest your money is going to earn for a set period of time, and there is no risk to your capital. The rising income also allows for inflation which bonds paying a level rate of interest do not.

"Most people see their costs go up over the years, so escalator bonds with their rising income may be more appropriate to their needs than, say, guaranteed-income bonds, which pay a flat rate of interest and make no allowance for inflation" says Amanda Davidson, a partner at the independent financial advisers Holden Meehan.

The income offered on escalator bonds is based on current interest rates. If you think interest rates are likely to rise in the future, you may want to hold back from investing in a fixed-rate bond as you may be able to get a better rate by waiting. But if you expect interest rates to fall the interest rates offered today could look very attractive in a few months' time.

Banks and building societies offering these bonds are aware of this and try to take a long-term view on the rates they offer. In recent weeks there have been a lot of changes to the interest rates offered on fixed- rate products, due to uncertainty over how soon the general election will be and the outlook for interest rates. But not everyone thinks interest rates will rise. Keith Sanham, a partner at the independent advisers Sanham & Co, says: "The market is on the move. There's political uncertainty and a gut feeling interest rates will go up. I don't subscribe to this view.

"I think the economy still needs some invigorating and interest rates at worst will stay where they are or probably come down in the next few months," he says.

But you may feel that in the current political climate it is better to remain flexible and opt for a short-term bond rather than, say, a five- year bond.

One of the latest bonds to be launched is a three-year one from Abbey National. It is paying an annual income of 6 per cent, rising to 7 per cent and then 8.5 per cent in year three. With the base rate currently at 6 per cent this seems a good deal, says Mr Sanham, as the interest rate would have to rise by more than 2.5 per cent over the next three years to match this rate.

However, income on these bonds is taxable, which means that for a taxpayer the net rates are significantly lower (so you may well be better off with a guaranteed income bond).

If you are a non-taxpayer you should ask for the income to be paid gross. Fill in form R85, available from either the Inland Revenue or the bank or building society with which you take out the bond.

Escalator bonds are ideal for those investors looking for a reliable income with no risk to their capital, but they are not the only products available with these features.

Non-taxpayers should also look at National Savings Income bonds or, if they are old enough, National Savings Pension bonds, while 20 per cent taxpayers should consider National Savings First Option bonds.

Banks and building societies offering escalator bonds include Abbey National, Bank of Ireland, Bank of Scotland, Barclays Bank, Birmingham Midshires Building Society, Coventry Building Society, Dunfermline Building Society, Halifax Building Society, Leopold Joseph, Portman Building Society, Royal Bank of Scotland, Sun Banking Corporation, TSB and Woolwich Building Society.