Do protected equity bonds offer value for money?
When considering the true cost of investing, one of the most difficult groups of products to compare are structured products.
These investments, which are most commonly offered in the form of guaranteed or protected equity bonds, offer returns linked to the performance of a certain index over a fixed period.
The main attraction of structured products is the capital protection they offer, but with some the amount of protection may also depend on the performance of the index.
They seem to give the best of both worlds: returns linked to stockmarket performance without a loss of capital if the index falls.
Firms that sell these products often argue that the charges are not meaningful because the pricing is integral to the returns offered. So investors will either get their original investment back or the return promised without any obvious deduction of charges.
Charges are normally taken out of investments in structured products at the outset and there is usually a deduction of five to 6%.
Around half of this is paid to the adviser in commission. Some execution-only advisers, such as Chelsea Financial Services, rebate part of the initial commission.
The remaining deduction goes to the structured product providers to cover the costs of their administration, marketing and custody fees.
If spread over the life of the products, which is typically five to six years, this deduction therefore equates to annual charges of around 0.5%.
The rest of the lump sum is used to buy the financial instruments that will provide the promised returns.
The main investment is in a fixed rate corporate bond, issued by a bank, that will pay out enough at the end of the term to restore the investor's original capital or whatever proportion of it has been protected.
The amount that needs to be invested in the bond depends on the interest paid by the bank. Some pay a higher rate of interest, which leaves the provider with more to spend on the derivatives that provide exposure to the index.
But it is banks with lower credit ratings that pay higher rates so they offer less security.
The remaining cash is used to purchase options to provide whatever level of stockmarket participation the product offers. The price of these options depends on market conditions at the time.
There are other hidden costs relative to investing in, say, an index-tracking investment fund. One is that the investor receives no dividends on the underlying shares. The gains may also be capped so if an index rises steeply investors will not get all the growth.
Conversely, if an investor buys a "capital-at-risk" product part of the capital may be lost if the index falls below a certain level, say 50% of its starting level, and has not regained its former level by the end of the term.
Another consideration is the type of tax payable on the final return. With some products, the return is treated as a capital gain, which means most investors will have no tax to pay if the gain falls within their annual capital gains tax allowance, which is currently £10,100.
But on other products such as National Savings & Investments Guaranteed Equity Bonds, income tax is payable on the returns unless the bonds are held within an ISA.
Some providers also charge exit fees if the investor does not reinvest in another bond at the end of the original term.
Are they value for money?
- With structured products you do not receive the dividends that make up the majority of the returns from shares over the long term.
- Your returns may be capped so you won't get the full increase in the share prices.
- You will be penalised if you want your money back early.
- If the stockmarket falls, you may get your capital back, but†its value will be less due to inflation.
- You will lose the interest you could have earned on a savings deposit. However, your adviser won't get the 3% commission for recommending that you stay in cash.
How a FTSE 100 Bond might work
The product offers 100% of the growth in the FTSE 100, capped at an index rise of 50%, with 100% capital preservation at maturity and a potential return subject to CGT.
1. £10,000 invested.
2. £600 is deducted in charges: £300 to the adviser in commission and £300 for custodian, admin and marketing costs.
3. Of the £9,400 left, £7,520 (80%) buys a zero coupon bond issued by a bank that returns £10,000 at maturity.
4. £1,880 (20%) is invested in a derivative, which provides capped participation in the growth of the FTSE 100.
5. After five years either scenario 1: the index has risen 50% and the investor gets £15,000; scenario twp: the index has risen 100% and the investor still gets £15,000; or scenario 3 occurs: the index has fallen 20% and investor gets £10,000.
6. If proceeds are not reinvested £150 is deducted at maturity.
This article was originally published in Money Observer - Moneywise's sister publication - in March 2010
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Describes the relationship between a client and a stockbroker or independent financial adviser whereby the broker or adviser acts solely on the client’s instructions and doesn’t offer any advice on which shares to invest in or financial products to buy and simply “executes” the wishes of the client, regardless if they are judged to be sound or wrong. Other types of broking service offered are advisory (whereby the client/investor makes the final decisions, but the broker offers advice) and discretionary (whereby the broker manages the portfolio entirely and makes all the decisions on behalf of the client).
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
A financial instrument where the price is “derived” from a security (share or bond), currency, commodity or index. The price of the derivative will move in direct relationship to the price of the underlying security. They often referred to as futures, options, warrants, interest rate swaps and contracts for difference (CFDs). They are mainly used for financial certainty – to protect against spikes in the prices of commodities – as a hedge, whereby investors can buy a derivative that bets the market will move against them so they protect themselves against potential losses. Derivatives are also a tool of speculation as they enable banks, traders or investors to bet on price movements without having buy the actual physical assets. As derivatives cost only a fraction of the underlying asset price, they are “geared” (leveraged in the USA) so if the price of the asset moves £1, the value of derivative could change by £10.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.