The pros and cons of guaranteed equity bonds

If you are a cautious investor, a venture into the stock market with a safety net in the form of guaranteed equity bonds may appeal.

These have soared in popularity in recent years, guaranteeing the return of your capital after the initial investment term (usually five years but there are some three year and six year options). They also promise a specified percentage return based on the growth of the stock market index, frequently the FTSE 100, which they are tied into. But a promise is not a guarantee; if the market tumbles so do your hopes of an easy return.

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Also, guaranteed equity bonds (GEBs) do not pay dividends; you are liable to income tax on any profits you might make, and you may incur a hefty penalty should you wish to withdraw your capital earlier than stipulated.

Not the most flexible of investment vehicles, then. Is the guarantee of capital return worth the price paid in foregoing dividend payment and the potential for tax inefficiency? If the market stagnates over the period of investment, your money will not have earned much. Inflation will have taken its toll and it could be that you would have been better off in an ISA or ordinary savings deposit account.

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Also, full capital retrieval is not always guaranteed. Depending on the GEB there can be certain ifs, invariably tied to specific conditions being met by the index your bond is tied into. GEBs offered by insurance companies or unit trust managers do not normally guarantee capital return in full.

However, full capital return is usually the case with the deposit-based GEBs available from high street banks, building societies, the post office, Tesco, Virgin, and government institution National Savings& Investments (NS&I). There is also no upfront administration fee.

GEB providers use the financial tool of derivatives to underpin this money-back guarantee. They're doing the actual stock market investing so they get to keep any dividends, while you get peace of mind. (If you invested directly in a stable market you could expect around 15% to 20% of your original capital sum in dividends over the five year period.)

Shares about to fall?

Second guessing stock market movements is very difficult, if not impossible. Some observers now see the beginning of a sustained period of falling share prices; the bull run in equities is over.

The cost of borrowing has increased significantly in recent months and investment banks are struggling over the financing of private equity deals.

09 August 2007 © Moneyextra.com

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