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

Your Comments

Excellent article - clear and helpful. Thanks!