Guaranteed Equity Bonds: High reward and low risks?

By Naomi Caine

8 June 2005

Can you invest in the stock market without losing money? Surely not: if the value of shares goes down, so does the value of your investment. In other words, you lose money.

But what if you invest in a guaranteed equity bond? About 200 of these bonds have come onto the market this year. They are everywhere – in the bank, building society, even the supermarket. National Savings & Investments, the government's own savings agency, is one of the biggest sellers of guaranteed equity bonds (Gebs). It has pulled in about £800m so far - and that's a lot of money.

The bonds are linked to the performance of an index, typically the FTSE 100. But they come with a guarantee that you will get your capital back at the end of the investment term if the index falls. No wonder they are doing a roaring trade. They seem to offer the best of both worlds so they appeal to investors who are nervous of equities, but still want the prospect of a high return from shares.

But have we really found investment nirvana, where you can combine low risk with high reward? NS&I is plugging the latest issue - number 10 - of it's Geb. And it boasts it is the most generous version yet. It lasts for five years and the minimum investment is £1,000. You get 125% of any rise in the Footsie at the end of the term, or your original investment back if the index drops.

Say you put in £10,000 when the index was at 5,000. After five years, the Footsie had climbed to 6,000 – a rise of 20%. You would get 25%, or £2,500 gross. If the Footsie had dipped to 4,900, you would simply get back your £10,000.

It looks like a win-win investment, but you can still lose out if the index dives. You don't earn any interest on your money over the five years, so you would actually be worse off after inflation. Your £10,000 would be worth £9,085 at today's CPI of 1.6%. If you had put your money instead into a savings account fixed for five years, you could expect to end up with £11,877.

Surely you win if the Footsie rises over the term because you get back 125% of the actual increase in the index? In theory, yes. In practice, maybe not. First, you get back only the growth in the index, not any dividends. Most experts stress the importance of dividends these days to bolster returns. If you look at the performance of the Footsie over the past year, you can see why. The index grew by 9% without dividends, but by 13% if dividends are included, according to Standard & Poor's Micropal.

Second, your profit is taxed as income not as a capital gain, which can make a big difference. If we use the example of the return of £2,500, you would actually get back £1,500 after higher-rate tax, or £2,000 if you deduct the basic rate. And if you were thinking of putting the bond in an Individual Savings Account (Isa) to escape tax, you will have to think again: the NS&I bond cannot be held within an Isa.

Patrick Connolly of John Scott & Partners, an independent financial adviser, has worked out the impact of tax and dividends. If you are a higher-rate taxpayer, the index would have to rise by more than 56% or drop by more than 28% over the term for the bond to beat a mixture of shares and cash. A basic-rate payer would have to see the index gain or lose 38%. Of course, it could happen. But nobody really knows the likely level of the Footsie in 2010? And remember, the bond does not allow you to withdraw your money half way through, so you can't pull out if it starts to go horribly wrong.

The NS&I bond will undoubtedly suit some investors. The agency also does a very good job of explaining how it works – and who should not buy the bond on its website (www.nationalsavings.co.uk). Basically, it is probably best suited to non taxpayers. Anyone else who wants an equity scheme that offers some sort of guarantee should look at the bonds that are subject to capital gains tax (CGT). You can often avoid CGT with careful planning and canny use of your annual allowance. Even if you can't, you can usually put this type of bond into an Isa.

Legal & General's Accelerated Growth Investment Plan 2 has a slightly longer term at six years, but you get back 130% of the growth in the Footsie. If you don't want to tie your money up for so long, Woolwich Capital Growth Plan 8 runs for five years and gives investors 120% of any rise in the index. Both schemes return your money if the Footsie falls and are available through financial advisers. Some, such as Best Invest, will even rebate some of their commission in the form of cashback.

Again, if the index slides, you might be better off in a savings account because of inflation. If it rises, you might make more from a simple tracker fund because you do not benefit from the dividends.

The guarantee is undoubtedly a comfort for many investors but – like most things – it comes at a price. And if you are really nervous of equities, should you really be buying a bond that is linked to the equity market?