Savings industry stares over precipice

With £5bn invested in high-risk, high-income bonds, Lloyds is not the only bank in danger

The customers of Lloyds TSB who walked out of their branch with a precipice bond in their hands are not the only ones surprised to feel the pain of a nasty fall in their investment. Yesterday's fine against the bank for selling the risky bonds to unwitting investors is unlikely to be the last.

Precipice bonds, or high income and growth bonds, have seduced investors with the offer of 30, 40, or even 50 per cent income over three to five years and their money back. This has lured in more than 250,000 investors in the past five years, who have parted with £5bn of their money.

But investors are discovering that nothing comes risk-free. "While the income element of the bond is guaranteed, the return of capital at the end of the investment term is dependent on what has happened to the particular index they track," Patrick Connolly, a director at the independent financial advisers Chartwell Investment Management, said yesterday. The small print that explained what would happen to investors' capital if the market fell off a cliff is now looming large.

Those who bought at the top of the market in 2000 could not have predicted the disaster their investment would become. As can be seen from the table opposite, a number of the bonds sold around 1999 and 2000 have left their investors with the little of their original investments.

For some it could not have been worse. The punters that plumped for a Canada Life stock-market-linked bond in 2000, when the Nasdaq 100 was at 3,553, may have got 31.5 per cent in income over four years, but they lost 100 per cent of their original investment when the bond matured in April this year. Nor was it much better for Canada Life's Platinum Bond holders, issued a few months later, who also lost all of their capital in exchange for 33 per cent income over three years.

"People wanted the headline income levels they were being offered and it never occurred to them that the market may start to fall. And if it did, they didn't think it would halve," Ben Yearsley, the investment manager at the Bristol-based firm of advisers Hargreaves Lansdown said yesterday.

There are also a number of bonds due to mature soon where only a miracle will save investors' capital from obliteration. For example, unless the FTSE 100 rises 50 per cent in the next six weeks, investors in AIG Life's Stockmarket Income Bond 1 could see a lot of their capital disappear. They will have bought in when the market was riding high at 6,374 in 1999 and for every 1 per cent it closes below this level, investors will lose 1 per cent of their capital. The FTSE 100 closed at 4,202 yesterday.

There are some investors staring at the bottom of even higher ravines. The NDF Extra Income & Growth Plan 3 started out following the Eurostoxx 50 in 2000 when it was 5,091. The plan matures next week, and the index is currently 106 per cent lower than where it was three years ago.

This particular plan has another nasty sting in its tail, common in precipice bonds, in the form of downside gearing. The plan has a 25 per cent safety net up to which the index can fall without risking capital. But if the index closes more than 25 per cent down on its start position, investors will lose 2 per cent of their capital for every 1 per cent it closes below the safety net. "This downside gearing effect multiplies the loss of capital you can experience, which has been one of the biggest problems with these bonds," Mr Connolly said.

This downside gearing is an example of the lengths the providers of precipice bonds have had to go to secure the double-digit income offers. As it became more difficult, providers found more complex - and riskier - ways of delivering it. This led to the emergence of bonds linked not to the familiar old FTSE 100, but to the more specialist Nasdaq 100 and the Eurostoxx 50. And they have also created bonds linked to baskets of stocks they thought would provide with the returns needed to pay back the capital at the end of the term.

This is what Scottish Widows did, on the basis that the 30 stocks it chose would be a microcosm of the FTSE 100. But only six of the stocks stayed above their safety net of a 33 per cent fall. Investors have lost up to 50 per cent of their capital.

Most equity investment is considered on a five-year outlook, which gives the chance for shares to recover if markets tumble. But precipice bonds were mostly set at three-year terms, narrowing the odds of an unrecoverable downturn. They also cap the upside gains to be made.

This means that investors that bought in 2000 caught none of the bull run in the market, took the full brunt of the following three-year slump and their investments have matured before the recovery can really get under way.

The FSA issued its first warning on the potential downside of precipice bonds in 1999 and has since made five more as the extent of the losses they can induce became increasingly apparent.

The regulator has been investigating a number of companies that have sold precipice bonds and this summer it pulled up seven firms for misleading advertising that did not make the risk to capital clear. All new marketing of precipice bonds is now accompanied by an FSA fact sheet detailing the risks of the product, much like the Government health warning stamped on every packet of cigarettes.

Lloyds TSB is undoubtedly the largest player in the high street sales of these products, and in dealing with Lloyds TSB, the FSA has now taken care of 20 per cent of the precipice bond market.

The FSA's attention is now focused on the other companies that directly market their products, where the onus will be on whether their advertising adequately pointed out the risks to consumers. GE Life, AIG Life, Eurolife as well as NDF have all sold their precipice bond products direct to the public. Independent financial advisers account for about 12 per cent of the market and are also being scrutinised.

"We do not have a problem with the products as such," a spokesman for the FSA said yesterday. "But we are concerned about the marketing of the products. While the risks are explained, sometimes only little is said about what happens to capital. It has to be made clear that high returns equal high risk."

But with only 250,000 investors in total, any further fines are not likely to be in the magnitude of yesterday's fine against Lloyds.

Stock-market-linked precipice bonds are, in the meantime at least, pulling themselves back from the edge, following the shocking losses they have delivered. Mr Connolly said yesterday that most new launches are on five-year terms, have little downside gearing and tend to follow the mainstream FTSE 100 index.

"The emphasis has now shifted on the people designing these products," Mr Connolly said. "Three years ago it was, 'These are the income rates we should offer and we will do whatever we have to do make sure we get them.' Now it is, 'Let's design a safe, less risky product that gives people some degree of protection and see what income rate we can offer it at.' Most stock-market-linked bonds now only offer income rates of 5 per cent a year."