We're backing the bonds that bucked the trend

Investors tired of poor returns are turning to distribution funds, writes Sam Dunn

In the current investment environment, tales of financial products flying off the shelves may appear exaggerated, yet sales of distribution bonds are soaring.

In the current investment environment, tales of financial products flying off the shelves may appear exaggerated, yet sales of distribution bonds are soaring.

The first six months of this year saw some 114,000 policies purchased - worth £500m - compared to 187,000 policies in the whole of last year, according to the Association of British Insurers (ABI).

And last year's total is more than double that of 2000, when investors bought just 80,000 distribution bonds.

So what is the appeal of these bonds? The answer lies in their ability to invest in commercial property, the disappointing performance of with-profit bonds and investors' aversion to equities.

The bond is in effect a wrapper within which to hold a stake in a life insurance company's distribution fund, so called because income is "distributed" to investors twice a year. A distribution fund generates money from its diverse assets, such as rental income from property, dividends from shares and interest from corporate bonds. The risk level for investors is generally considered similar to that of a "cautious managed" fund, says Anna Bowes, investment manager at independent financial adviser (IFA) Chase de Vere.

Patrick Connolly, director at IFA Chartwell Investment, says: "With banks and building society rates going down and bonuses on with-profits investments falling, the bonds do appeal to people looking for income because it's difficult to get such an income stream [elsewhere]."

The insurer Norwich Union launched a distribution bond in July. Keith Simm, investment marketing manager at Norwich Union, says the product is intended for investors with "a relatively cautious outlook". And he adds: "Investors might expect income growth of some 4 to 5 per cent and some capital appreciation too."

The Norwich Union fund is 40 per cent invested in shares, 40 per cent in bonds and 20 per cent in commercial property. Before you sign up for any distribution bond, it's important to check the mix of assets with your IFA because each of the 32 funds on the market has a different focus.

Investing in a distribution fund also has tax benefits; higher rate taxpayers can defer an annual 5 per cent tax-free withdrawal until cashing in their bond. This can be extremely tax-efficient; a pensioner who was previously taxed at the higher rate and becomes a basic-rate taxpayer at the time of cashing in the bond won't have to pay the deferred tax.

You can invest in a distribution bond either directly or through a distribution unit trust run by an investment house such as New Star or Jupiter. The appeal of distribution funds for regular unit trust investors is that, after the abolition next April of the 10 per cent tax credit on dividends in individual savings accounts (ISAs), they will offer valuable tax breaks. As long as 60 per cent of the fund is retained in bonds, the interest generated in an ISA will be free of tax because it is not treated as a dividend.

As with with other investment bonds, you should expect to pay an initial fee of about 5 per cent of the amount invested, plus a 1 per cent annual management charge.

Not everybody is a fan of the principle behind distribution funds. Asset management company Isis brands the 60/40 per cent bond/equity fund a "fad". Its own Managed Distribution fund is more flexible, which should allow managers to take advantage of any share rallies. When it adheres to the 60/40 ratio it enjoys the tax benefits, but when it doesn't, its income is classified as dividends and therefore liable for tax.