Caution's the watchword

In the uncertain aftermath of Tuesday's atrocity, investors should batten down the hatches and play safe, say William Kay and Tom Tickell

The terrifying terrorist attacks in the US last Tuesday have had an inevitable impact on financial markets. It is still too early to say whether that impact will be temporary, or will translate into a long-term shadow across the investment scene. But it is certainly time for individuals to reassess their financial position, and make precautionary moves to protect their assets and minimise their liabilities in case of the worst.

The terrifying terrorist attacks in the US last Tuesday have had an inevitable impact on financial markets. It is still too early to say whether that impact will be temporary, or will translate into a long-term shadow across the investment scene. But it is certainly time for individuals to reassess their financial position, and make precautionary moves to protect their assets and minimise their liabilities in case of the worst.

The long-awaited share-price slump, threatened but ultimately stopped short on Monday, was given full rein the following day as millions watched the horrific events unfold on television. It may take weeks or months to arrive at an accurate judgement of the full implications of Tuesday's events, and it is certain to take at least as long for the confidence of savers and, equally important from the investment point of view, that of spenders to be restored.

The effects are likely to be far more widespread. People will be less inclined to travel, especially by air, and may be less keen on other avoidable spending, on leisure and so on. At this stage it is hard to assess how far the knock-on could hit the world economy, but it has the potential to take the stuffing out of the US consumer spending boom and that could spiral round the globe.

At the very least it is a time for investment prudence, despite the risk that that may produce a self-fulfilling prophecy of gloom. The first and most fundamental step in that direction is to cut debt as far and as fast as possible. Pay off credit cards and try not to borrow any more on them. Sell easily cashable assets to repay personal loans and as much as possible of mortgages. These are good investments in themselves, because there is no tax on the interest you save, which is even more valuable than interest earned but taxed.

One step is to remortgage to take advantage of lower interest rates and better deals, although several lenders have clamped down on this. But there are other things you can do to reduce the bills. Postpone large spending plans, such as house moves or extensions, if circumstances permit. Flexibility is vital, and that means conserving cash.

Those who are directly or indirectly invested in equities for capital growth should consider selling at least their more ambitious holdings. There must be a realistic prospect of being able to rebuild such portfolios at lower prices next year.

Income-based equities should hold up better, providing they are soundly based. Shares or unit trusts which carry high yields because of hoped-for recovery prospects should be ditched. Such prospects may have been postponed for some time.

It is tempting to bolt into a so-called protected fund, which some investors fondly imagine offers both peace of mind and the chance of big profits. But Marc Gordon, the managing director at Close Fund Management, which runs the only 100 per cent capital-protected fund, said: "Our message to investors is to consider the risks they are prepared to take."

The Close UK 100 Escalator Fund uses options to cut the risks of direct stock market investment, but allows investors to reap some of the long-term rewards without the volatility. The fund invests in options on the FTSE 100 and aims to protect 100 per cent capital from stock market falls and lock in gains every three months. Since its launch in January 1996, growth has been 32.5 per cent offer to offer, with net income withdrawn, compared with 34.8 per cent for the FTSE 100 Index itself. The difference is largely sunk in the cost of the options. As a yardstick, Halifax's Liquid Gold Account has paid 14.9 per cent on a similar basis. The Close fund has a minimum investment of £1,000 and regular savings start from £100 per month. Call 0800 269 824 or visit www.closefm.com.

If you have long-term savings contracts, such as pensions or with-profits bonds, stick with them if you can. Penalties for surrender are rising, and they are, after all, about the long term. Selling those with only a few years left to run will mean missing out on any terminal bonus, and if there is more than five or 10 years in the contract it should benefit from the market's eventual recovery. And if you have spare cash, do not leave more than you have to on deposit. The interest rates are generally lousy, could well become even lousier, and can be easily bettered. These are some of the more attractive alternatives.

High-income bonds

These commit you for a fixed period, typically two to three years. They guarantee to provide you with an all-but-guaranteed income, which can vary from 7 to 10 per cent or more. The risk is that your capital will be eroded to produce that income, and you will receive less than you started with.

Each plan is linked to a particular stock market index, and will return your original stake in full only if that index hits certain targets. Some bonds have two hurdles, so if the index fails one test, you still get all your money back if it passes the other. But everything depends on the fund and its small print.

GE Life's high-income bond claims to offer 10.25 per cent as an annual rate over three years. Alas your investment ends, not after three years, but after three years and two months, which brings the effective return down to 9.71 per cent. That is problem one. The other is that the group is offshore, and the figure is before tax; you have to pay your bill to the Inland Revenue on it. Most other high-income bonds quote net rates, and on that basis the 9.7 per cent is actually worth 7.58 per cent.

Your capital will be tied to the Eurostock 50 index covering the biggest 50 euroland companies, including the food manufacturer Nestlé and Phillips, the electronics giant. If that index has not fallen by more than 20 per cent at any point during the bond's three-year life you get your money back in full. And you get your money back in full if the Eurostock 50 is at or above its starting point when you invested, whatever's happened.

Chartwell, the independent financial adviser, has a similar

bond onshore, offering 7.25 per cent net. The same two tests apply in this case, but this time the Eurostock index has to fall by 30 per cent before you are in danger of losing capital. Eurolife's high-income bond offers an attractive 10.5 per cent, and looks safe with its link to the top 10 groups in the FTSE index. This time you can lose capital only if any one of those stocks drops by more than 20 per cent.

"That one-company rule is worrying when four of those top 10 companies are banks," says Anna Bowes of the independent adviser Chase deVere. "They stand to lose the most if any downturn proves to be severe. I am wary of putting any capital at risk, because of what could happen to one company."

Corporate bond funds

These also pay good income, but carry correspondingly bigger risks. Most big City names offer them, including Fidelity, Barclays and Framlington, and they typically provide returns of around 8 per cent.

Corporate bonds are just loans to companies, and there is a distinct pecking order. Giant companies such as HSBC, because they are deemed to be low-risk, will pay much less interest than smaller and potentially more vulnerable businesses. Most bond funds also include some British gilts, and European and US Government stock. The higher the returns on a particular fund, the poorer the "investment quality" of its holdings. The income itself can fluctuate, though it does not usually. The capital is a different story, as the table on the previous page shows.

"Falling interest rates tend to push down values, but the developing recession has meant more companies defaulting on their loans," says Patrick Connolly, of Chartwell, the independent financial adviser. "Several bond funds lost out badly when the telecom bubble burst and firms went bust."

News of cutbacks and redundancies has increased the concerns. In the first three months of the year, 40 quoted companies round the world defaulted on their loans and Standard and Poor's, the credit rating agency, gloomily forecasts that this year may be among the worst for defaults.

Guaranteedincome bonds

These are savings plans, not investments, and they offer fixed returns if you invest for a fixed period. Life companies issue them, and two big groups in the field are AIG Life and Pinnacle Insurance. Neither is a household name, but both have giant parent companies behind them

The average return is around 4.75 per cent on these bonds, but it will vary not just from group to group, but also with the sum you invest, and the time for which you are prepared to commit it.

PIBS: permanent interest-bearing shares

These come from building societies, usually raising finds to strengthen their balance sheets, to cover themselves against such events as a massive drop in house prices. At present, nine societies including Britannia, Nottingham and Coventry, offer them.

PIBS carry fixed rates, though these can vary sharply. Nottingham pays 7.78 per cent but wants a minimum investment of £5,000. Britannia pays 13 per cent but that makes sense only for big investors.

PIBS have no fixed life, and you cannot cash them in with the building society which issued them. You have to go to a stockbroker and sell them on the stock market. Anyone planning to buy PIBS should seek professional advice.

The iron rule is that the more attractive an offer looks, the bigger the risk to the capital that you invest to get it. Barlow Clowes investors found that to their cost a decade ago, and the rule applies as strongly as ever today.

Contacts: Chase de Vere (01225 469 371) and Chartwell (01225 312 700)