MONEY COMMENT
The High-Income Bond Scandal

By Stuart Watson (TMFTiger)
February 4, 2003

Here we go again. The latest financial scandal is beginning to rear its ugly head. Over the last few years, many investors - seeking refuge from turbulent stock markets or simply not willing to take too much risk - have invested in a wide variety of high-income products.

The problem is that, in many cases, these people didn't realise - and apparently weren't properly informed - that what they were buying was still linked to the stock market. Many of the products were highlighted as "guaranteed", but what wasn't made clear was it was only the income paid out that was guaranteed and not the initial capital. Of course, it's not much good getting a guaranteed income of 8% a year for five years if you lose half your capital in the process!

Many of these bonds have complex structures, so it's hard to appreciate the level of risk that you're taking. Even if you're a fairly sophisticated investor, it's relatively easy to miss some of the more subtle risks in the small print. And, arguably, those least able to appreciate the risks are exactly the sort of people that go for these sort of products in the first place, especially when they are given such reassuring descriptions as 'Guaranteed' and 'Bond'.

It's reckoned that about a quarter of million people have invested in these products. The Financial Services Authority first issued an alert about them in December 1999, but the level of complaints has risen rapidly recently and is expected to increase as more and more bonds mature over the coming years.

So, how can you take steps to ensure that you don't get burned?

• It's vital to appreciate that aiming for an income higher than that paid by gilts (4.3% at the moment) inevitably means you are taking some risk with your capital, even if that risk is not readily apparent. The higher the level of income, the higher the level of risk to your capital. It's a cliche but "if it seems too good to be true..."
  
• Don't forget that inflation is low at the moment. Although it may seem that you're getting less for your money because interest rates have fallen, the flip side to this is that the real value of your capital is falling far less quickly than it has in the past. So don't feel you have to take greater risks in order to stretch your money that bit further. 
  
• As with any financial product, never buy what you don't understand. Ask what risks there are to your money and demand they be explained. If you're not happy or are still unsure, even after all the explanations, walk away. There'll be plenty of other decent investment opportunities out there.

More: The FSA Guide To High-Income Products