Bonds keep us interested

For a rock-solid bond that pays fixed interest with guaranteed returns, buy gilts

THE WORD bond applies to a wide range of investments, and although they lack the glamour of Ian Fleming's fictional 007, they should make up for it in reliability, writes Harvey Jones.

Traditionally a bond is a fixed-interest security issued by a company or government. In practice the word applies to a range of products where you pay a lump sum and in return receive interest (sometimes for a fixed period) plus your capital back at the end.

Most common are with-profits bonds issued by life firms, which appeal to the cautious investor. They aim to provide a steady return through investment in a wide range of shares, gilts and property.

Essentially they are whole-of-life insurance policies, but with an investment element. They pay an annual bonus plus a further bonus at the end of the term, called the terminal bonus. Annual bonuses are typically 6-7 per cent before tax.

You retain the annual bonus whatever happens, but the terminal bonus depends on the performance of the fund. This is the greatest element of uncertainty, although the aim of the fund is to smooth out short- term market fluctuations.

With-profits bonds have several advantages, says independent adviser Brian Dennehy. The insurer issuing it pays the basic rate of tax direct from the fund, and top-rate taxpayers only pay the difference at the end of the term.

If the policyholder has retired or fallen into a lower tax bracket when the policy matures, they will not pay the extra tax. Furthermore, 5 per cent of this investment can be withdrawn tax-free each year.

There are other questions to consider, however. First, your money will be locked in for five years. Second, you should examine the financial strength of the insurance company.

Insurance companies also offer distribution bonds that pay investors a regular income without eating into the original investment. With most distribution bonds, income earned can be reinvested and, depending on the performance of its assets, the capital grows.

Distribution bonds are marginally more risky as your income is stock market dependent, and therefore does not benefit from the smoothing effect that keeps with-profits bonds steady.

David Turner of Scottish Provident says investment bonds offer a wider range of options than unit trusts or investment trusts; they provide a choice of guaranteed or protected funds that may appeal in a volatile market, and it is usually cheaper to switch between funds than unit trusts.

A word of warning. If you have a financial adviser who recommends you take out an insurance company bond, ask what commission he will earn before making a decision.

Two different types of bonds that are easily muddled are guaranteed income bonds and stock market linked bonds. The former provide a guaranteed return over a fixed period, usually five years, which you can take as income or a lump sum when the term ends. Your original investment is also returned. The advantage is security, but at the cost of lower returns, at 5 per cent or less.

Stock market linked bonds, often called high-income bonds, typically offer a guaranteed income of around 9-10 per cent a year over five years, but your capital is not guaranteed. If the stock market performs badly over the term, your income could end up being paid out of your capital.

If you want a rock-solid bond paying fixed interest with a guaranteed capital return then buy gilts. With inflation low you should see a healthy return. Gilts are sold by the Bank of England (0800 818614) and interest on gilts is taxable.

Corporate bonds are similar to gilts, but being issued by companies means there is an element of risk.