MONEY COMMENT
Guaranteed Blue-Chip Returns

By Cliff D'Arcy
March 19, 2004

One problem that investors in shares face is the risk of losing money, even over a five-year period. For example, from 1998 to 2003, the FTSE 100 index, which measures the value of the UK's one hundred biggest firms, fell by almost a quarter (24%). Even investors who reinvested their dividend income would have recorded a loss of almost 13% over the same period.

The risk of suffering a capital loss discourages many people from investing in shares. Instead, many stick to saving money on deposit, which means their money usually barely keeps up with inflation (rising prices). This is a shame, because the stock market can be very rewarding over long periods: since 1918, it has returned around 11% a year on average, with dividends reinvested.

Financial firms have tried to lure savers into becoming investors using Guaranteed Equity Bonds (GEBs). I've criticised Guaranteed Equity Bonds in the past (for example, here and here), because they are often poorly designed and offer unimpressive returns if the stock market does do well.

The idea of GEBs is simple: you invest a lump sum that is tied up for a fixed period (usually five years). At the end of the term, your return is based on the performance of one or more stock markets. On the other hand, you get your money back in full if the market has fallen, which many people find attractive!

The key problems with GEBs are:

• You don't earn any income from these bonds, whereas you would by investing directly in shares. Currently, the FTSE 100 yields 3.4% a year. Compounded over five years, this is worth 18% of your initial investment. By investing in a GEB, you lose out on this lovely income.
• Inflexibility: your money is locked in for five years, so you can't withdraw any of your initial investment, nor can you add to it. This means that GEBs are only suitable for patient lump-sum investors.
• Few investors know that the FTSE 100 has only fallen seven times in the 130 five-year periods since 1869. However, two of those falls occurred very recently (1997-2002 and 1998-2003), so financial advertisers exploit recent events syndrome to promote these bonds!
• Thanks to inflation, your money will be worth a lot less in five years' time, so you'd still lose out even if you got all your money back by triggering the bond's guarantee. In fact, inflation at 2.5% erodes the value of your money by around 12% over five years.

Even so, the government's savings arm, National Savings & Investments, yesterday launched a pretty decent GEB. Here are the details:

• It pays 110% of the growth in the FTSE 100 between 19/05/04 and 19/05/09, with no upper limit or cap*
• You can invest between £1,000 and £1 million (£2m for couples)
• It is on sale between 24 March and 18 May at the latest (interest of 3.25% will be paid on capital held until the bond begins)
• Your capital is returned in full if the market falls over the five-year period
• This is a completely secure investment, as it is backed by 'the full faith and credit of the government'
• There are no other fees and charges, plus no commission is paid to middlemen
• Unfortunately, this bond cannot be bought within an ISA or PEP, so gains will be liable to income tax at the investor's highest rate when the bond matures in 2009. Note that your profit is taxed as savings interest, not capital gains, so you can't use your annual CGT allowance to avoid this tax!

* The start and end index levels are averaged over the first five days and last six months of the bond respectively.

Note that the 'participation rate' is 110%, which means that your profit is 44% if the index rises 40%. This is one of the highest rates I've come across, but other stock market investments should beat it, thanks to reinvested dividend income:

Five-year returns
Increase in FTSE 100 index	0%	20%	40%	60%	80%	100%
Total FTSE 100 return*	18%	38%	58%	78%	98%	118%
Pre-tax return from this GEB	0%	22%	44%	66%	88%	110%

* Including reinvested income of 18%. Please note that this is a hypothetical return and the actual return will be reduced by product charges.

In fact, a cheap, simple, flexible index-tracking ISA would be a better bet if the Footsie rises by 180% or less, which it is fairly likely to do. However, if you can't afford to risk losing any of your capital, but would like to try to beat returns from your deposit account, this GEB may be for you.

More: Hidden Costs Of Guarantees | Guaranteed Stock Market Returns | More Guaranteed Returns.