And your money back, guaranteed

Market-linked bonds now offer the thrills of equity investment without the spills.

Although PEPs and privatisation sales have helped make share owning more popular, the vast majority of savers are nervous about investing in equities either directly or indirectly via unit and investment trusts. Equities are too volatile for them with no certainty about the returns.

As deposit-account rates have fallen, however, rates on bank and building- society accounts have dwindled leaving investors looking for better rates plus security and insurance companies have been only too pleased to meet this desire. In the last couple of years, many of the large life-assurance companies have stepped into the breach with a new generation of fixed- term bonds with high guaranteed income, and tax free to standard-rate taxpayers.

It is important to note that there are two distinct types of bonds on offer. The guaranteed income bond first popular in the Seventies still exists. GAN Life offers 4.4 per cent on pounds 3,000 for just a year, Pinnacle is offering 6.1 per cent on pounds 3,000 for three years and London & Edinburgh 6.25 per cent on pounds 3,000 for five years. The interest is guaranteed, is paid free of basic-rate tax and offers a full return of capital at the end of the fixed term.

Variations on the theme include the Sun Alliance Azalea Income Bond which offers 6 per cent net annual income plus a full return of capital at the end of five years with a bonus of up to 6 per cent of the original investment depending on an increase in Japan's Nikkei 300. NPI's Guaranteed Investment Bond will return 6.5 per cent net per annum for six years. At the end of the period, if the FT-SE 100 has more than doubled, the investor will get back the lump sum plus half of any increase in the index over 100 per cent.

There is, however, a very different type of bond also on offer, the high income bond, which has attracted the most money. It offers a significantly high guaranteed income, 8-10 per cent net of basic-rate tax or even higher, or a fixed return if no income is taken. But in order to offer a full return of capital, there is a significant risk of which the investor is often totally unaware.

A proportion of the money, anything up to a half, goes to purchase annuities that provide the fixed income. The rest is invested by the insurance company in a variety of equity-based investments, usually derivatives such as swaps and options, based on one or more of the leading stock-market indices in the UK, US or Japan. Typically, an insurer will go to a leading investment bank for these derivatives.

For the investor to get a full return of capital as well as the income, the chosen index has to perform over the life of the bond. These days, it is usual that the chosen index should be at least the same level at the end of the term. Otherwise, the income will start to be drawn from the capital - although insurers usually guarantee that the total return including the income will at least equal the original investment.

Over time, the conditions attached to high income bonds have improved. In the past, they often required the linked index to appreciate by some percentage or other before there was a full return of capital. Now the best ones require no growth at all.

The Personal Investment Authority has, however, recently voiced its concern that some investors are being misled and that the only "guarantee" is the income part of the bond. The Department of Trade and Industry has also issued guidelines that the equity-linked part of the bonds should not be invested through just one counterparty. But just as bookmakers lay off bets, so investment banks lay off the investment money through the use of different derivatives using different intermediaries.

As long as investors know the risks involved, a high income bond can be an acceptable part of a portfolio. Because of the different rates of return on offer, minimum investment, fixed investment periods, and the different indices, comparing the current crop of high income bonds is like comparing apples with pears.

One of the best on offer is the Abbey Life High Income Bond. Closing on 1 July, it gives an income of 10 per cent net a year or 0.78 per cent a month to basic-rate taxpayers or an accumulated 60 per cent net at the end of five years. It carries a higher risk than some because the full return of capital is guaranteed only if a combination of both the FT-SE 100 and S&P 500 are no lower at the end of the five years.

While the Abbey Life bond is about to close, Scottish Mutual is about to open its new High Income Bond,which will pay an income of 10.5 per cent a year or 0.82 per cent a month net of basic-rate tax, or an accumulation of 65 per cent at the end of five years. Again, the full return of capital, as well as the income, depends on the same two indices not falling over the five year period. Like all the large insurance companies, both Scottish Mutual and Abbey Life average out the final 12 months of each index to avoid last minute stock-market fluctuations.

Other bonds on offer at present include Johnson Fry's Income Safeguard Bond which will pay 8 per cent net a year or 55 per cent growth after five-and-a-half years providing neither the FT-SE 100 nor the S&P 500 falls more than 20 per cent. If the market does well, the investor will receive a bonus. GAN Life & Pensions offers its Blue Riband Guarantee returning 10 per cent net a year for five years with a full return of capital providing there is no fall in any one quarter for the FT-SE 100.

Guaranteed bonds are virtually risk free but do not offer the highest rates of return. The high income bonds carry the risk that if the linked index falls over the investment term, some of the capital will be used to supplement the income payments. All, however, guarantee that the total payout including income will never be less than the original lump sum investment.

As Ian Millward of Chase de Vere, the independent financial advisers, comments "Investors have to weigh up the pros and cons of any high income bond offer. They should tread warily and look at the small print. Provided they are satisfied with the risk, then the bonds could form a part, but not the whole, of an investment portfolio".