Capital protection at an investment price

There's nothing like a touch of shares turbulence for renewing cautious investor interest in ways to protect capital whilst having exposure to the stock market. The FTSE 100 has tumbled from its high point in recent weeks, not dramatically (dramatically enought on some days!) but sufficient to prompt financial institutions to promote (and the media to speculate on) the efficacy of capital protected investments.

What are these seemingly 'have your cake and eat it' investment schemes that allow the return of capital after the stipulated investment term (usually five years), even if equity shares meanwhile have dropped into oblivion?

Capital protected investments have include such chimeras as high income bonds and precipice bonds, but by far the most common now are guaranteed equity bonds (GEBs). Only these guarantee to return your investment in full on maturity of the term; other types of bond may offer higher returns, but various 'ifs' and conditions apply to full capital retrieval, depending on the stock market index the bond is tied into.

Your capital can be guaranteed, but you get no dividends. Usually there is no upfront administration fee, but the lack of dividends and the possibility of penalty charges if you withdraw early negates the traditional approach to investing on the stock market.

The GEB provider gets the dividends, you get the capital protection and a specified percentage return based on the growth of the index. Whether you think this is a good trade off depends on your attitude to risk.

Although financial experts and advisers are divided on the merits of GEBs, arguing that dividend exclusion makes for a big difference in returns (the FTSE 100's past five years return of 13% includes dividends; without them it has fallen by 4%), many of us remain cautious in our investment habits. So much so that over 50,000 investors have contacted National Savings & Investments, the government-backed leading GEB provider, about its latest bond in the past few weeks.

As of last year customers had invested over £900 million in NS & I guaranteed equity bonds. Other than NS & I, banks, building societies and the Post Office are among those offering GEBs that guarantee capital return.

How much growth is on offer?

Such bonds do not have set interest rates, but they do offer potential growth. This is achieved by tracking stock market indexes; the average growth in the index (it might be one or as many as four) specified is calculated over the term of the GEB and the investor is paid a percentage of this growth. The percentage return varies according to the bond invested in, but the principle remains the same. You get a return at the end of five years provided the underlying index has not fallen below the level of its 'strike price' (where it stood on day one when you invested in the bond). You also get your capital back.

However, if the index is below the strike price at maturity then your capital is all that you do get back; theres no percentage return on top. Some percentage returns are fixed at the outset, say 30%, while others are proportional to the rate of growth in an index.

Such 'participation' bonds, as they are called, have the potential of good returns in a bull market although participation rates can vary between providers, ranging from 55% up to 150%. An example is NS & I's rate of 112% on its five-year FTSE 100-linked bond; a 20% index rise over the period would mean a return of £2,240 on a £10,000 investment.

Returns can also be capped with a ceiling set on the percentage paid out, regardless of whether the index's growth exceeds this level. For instance, Abbey gives a capital guarantee plus 130% participation in the growth of FTSE 100, but returns are capped at 50% of the initial investment.

Of course returns can be higher with bonds that do not fully protect your investment. For instance with Barclays' Super Tracker, which pays four times the growth in the FTSE 100 (50% cap), if the index falls by more than 50% at any point during the five-year term and fails to recover to the strike price, you will lose 1% of your capital for every percentage point fall in the index.

The key things to consider with capital protected investments, other than the extent of protection and your own attitude to risk, are the index or basket of indexes being tracked and how the growth is calculated. Most plans use average market value over a certain period, such as the average of index daily closing levels during the final 12 months.

Do you need capital protection, which comes at the cost of diluted returns on the investment? Experts argue that cautious types who dont want to invest in equities shouldn't consider these schemes and, if nervous but prepared to have shares exposure, then a properly constructed portfolio would be a better option.

Returns are mediocre however you view it: in a good market you forego some of the growth as well as dividends; in bad times you only get your capital back, with no interest. Meanwhile inflation will have nibbled away at its value and, given that income tax has to be paid on any returns, you might well have been better off with a five year run of cash mini ISAs.

Furthermore, unless you know with crystal certainty that the recent FTSE 100 tumble heralds the start of a very long bear run and the economy will implode, why get fazed by, and seek protection from, a relatively minor blip in the index?

12 June 2006 © Moneyextra.com

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