Time to invest again after hitting point of no returns

Published on Saturday 5 September 2009 13:46

WITH stock markets having climbed nearly 40 per cent since March, many investors will be wondering whether now is the time to get back into equities, or have they missed the boat.

Many remain understandably nervous, not least as October looms, the month most associated with stock-market crashes. One option which can be attractive in uncertain times is guaranteed investments, which promise investors their money back, come what may, plus a share in any growth in share prices.

In contrast, institutions are rushing to cash in on new-found confidence with a flurry of activity in the guaranteed equity bond sector. Nationwide, Abbey and the Post Office have new issues of bonds open for subscription over the coming weeks.

They are not alone. Investec runs nine of these plans, with Britannia, Barclays, Coventry, Skipton and West Bromwich building societies all competing for investors' money.

But their bond offerings are difficult to compare as they operate in different ways. Returns can be eyecatching but may fail to live up to the tempting levels suggested .

As a guide on how best to steer a course through the pitfalls, some common questions are answered below.

What are guaranteed investment bonds?

They are an investment vehicle that normally pledge that investors will get their money back, plus a minimum return, come what may. Typically they run for five years or longer, although the Abbey has some which last three-and-a-half years.

Are they always directly linked to the stock market?

No. Some shadow property indices, while others guarantee a certain return provided the FTSE index of shares in UK's top 100 companies rises. But these do not pay a return based on that increase.

How does the property bond work?

Abbey, for example, has two bonds linked to the Halifax House Price Index. The three-and-a-half year bond will pay out half the rise in the index, plus the investor's money back. If the money is invested for five-and-a-half years, it will pay out 75 per cent of the rise in the index. Even if it falls, the investor will get a 7 per cent gross return on the first bond and 14 per cent on the second.

This equates to an annual return of 2 per cent over three-and-a-half years or 2.5 per cent over five, which can bettered in a good savings account, particularly given that interest rates are expected to rise.

Otherwise investors are relying on the upward swing in property prices. Allowing that they can currently earn around 5.5 per cent on a five-and-a-half year bond, property values would have to rise by more than 40 per cent to make it worth while, or 8 per cent a year.

Investors should also be aware that the "growth in the index" will be taken from September's house price figure, but measured against the average of the seven monthly property values prior to the investments' maturity, which can suppress profits.

What if the investor just want a guaranteed return?

This simply requires the FTSE to have grown in order to pay a pre-set percentage. The Post Office, for example, pays 35 per cent over five years, which is equivalent to a 7 per cent annually (or 6.18 per cent allowing for compounding), provided the index rises or stays the same. If it falls investors get their money back. This bond closes on September 26.

Abbey has a similar bond for three-and-a-half years paying 18 per cent if the FTSE stays the same or rises, or 40 per cent over five-and-a-half years. If the index falls, investors get their capital back plus 0.25 per cent or 0.5 per cent respectively.

Coventry building society pays 32.23 per cent on another lookalike product or 22 per cent with a guarantee that the lowest return will be 11 per cent over five years. Legal & General's offering yields 26 per cent over the five year term.

The Britannia has a whole range of these bonds paying different sums over different periods, provided the FTSE rises.

Essentially the institutions invest, say, 70 per cent of the money in a corporate bond, which guarantees the return of capital, and then buys derivatives with the rest of the cash, to lock into any market upswing.

Is it worth opting for a higher exposure to equity markets?

These will link any return directly to a stock market and then cap it. Nationwide, for example, has a six-year bond which will pay the 100 per cent of an equity return based on the average rise in the FTSE 100, S&P 500, and DJ Europ 50, but only up to a return of 55 per cent. Anyone interested in this vehicle should note that the final figure is based on a daily average of the last year.

Similarly, Abbey pays half the FTSE but capped at 40 per cent, with a guaranteed minimum return of 14 per cent over five-and-a-half years.

Barclays variation pays twice the rise in the FTSE over the plan, but capped at 45 per cent.

Are they worth it?

Investors are giving up a great deal for the sake of the guarantee. Not only will they receive only a percentage of the rise in the indices, but they are foregoing dividend income for five years. These vehicles are also very inflexible, and investors can see their capital cut if they try to withdraw funds early.

A plan bought five years ago, for example, which is currently maturing, would pay back the original investment but not much more as markets are roughly back where they started in 2004.

In between, share index rose from about 4,500 to 6,500, and back down again, bottoming at 3,510, before rallying to close on Friday at 4,848. Investors who opted for the security of a bond, rather than a managed fund, will have foregone an increasing dividend income stream, and been unable to sell out as markets slid.

Against this, those with a slightly different time horizon would not have suffered potential losses to their capital when shares bottomed.

How have they performed historically?

This is part of the problem. We don't know. Institutions are very coy about their past performance, and as each issue is different, they claim it is impossible to compare.

Are there any other pitfalls?

Investors should always check that their capital is absolutely guaranteed. Those who bought into higher returns on income bonds were shocked when they discovered, as their income rose, capital diminished, as the superior returns were being paid from the lump sum.

Unfortunately, these bonds have not been scandal-free. Lehman Brothers was a counter-party handling the derivatives on some bonds, and the collapse in Key Data Services, which specialised in structured investments, has been mired in controversy.

But these episodes, should not cloud investors' view of other reputable companies.

How are these schemes taxed?

This is where they become interesting. As equity investments they can be counted towards an equity Isa annual allowance, allowing investors who maximise their annual cash Isa limit to shelter more of their nest egg from tax, without risking it all on stocks.

The annual Isa limit of 7,200 will rise in April to 10,200, except for the over-50s who get the increase from 6 October. The cash limit in the overall allowance will rise from 3,600 to 5,100. The remainder can be invested in shares, or in guaranteed equity bonds.

What happens if a company goes bust?

As with any guarantee, it is only as good as the institution that offers it. But should a company go bust, these investments do not have to rely on deposit-type protection, but qualify under separate investment rules, which means investors should get a maximum of 48,000 from the Financial Services Compensation Scheme.