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Cracking the safe

Gone are the days when income came from a bank account or from dividends. Today, a complex and diverse range of products exists to accommodate short to long-term income requirements.

The good news for investors is that competition in the market has led to innovation and greater reward. The problem for many remains – where do you start?

Cautious investors have traditionally looked to banks and building society accounts to provide them with a “safe” source of income. Unfortunately, this sense of security can often be misguided, with many investors failing to realise, unless the rate of interest paid is significantly above the rate of inflation, their savings are being eroded in real terms. There arefew worse homes for investors&#39 money.

The range of investment products developed tocombine security with improved returns includesconventional annuities, fixed-interest stocks, permanent income-bearing shares and guaranteed income bonds. These offer security but, with returns at the 7 per cent mark, are unlikely to set the world alight.

Products which can yield higher returns include annuity bonds, investment products which are linked to direct investment in equities or through unit trusts/Oeics, junk bonds and guaranteed equity bonds. With-profits bonds and annuities offer good returns, but can only ever be considered as long-term investments. Junk bonds have a level of risk that many investors find unacceptable but they should not be dismissed since they are underwritten by highly reputable organisations.

For some investors, direct equity investment is too much. Thebenefit of unlimited growth potential is outweighed by the possible capital risk of such products. Risk-averse investors will still be interested in, and will benefit from, exposure to stockmarket-linked investments and will be willingto trade some growth potentialfor capital security.

Most risk-averse investors are likely to be either over 50 or first-time investors. As the baby-boomer generation moves into middle age, risk-averse investors are likely to account for an increasing percentage of active investors and the demand for low-risk investments is likely to increase.

One attractive solution to the risk versus return dilemma is the guaranteed equity bond and other stockmarket-linked investments. Both are offered by number of providers although offers may not be continuous throughout the year. They are usually available over terms of between three and six years and provide fixed income or a fixed-growth option although the final capital is linked to one or more stockmarket indices. Importantly for risk-averse investors, invested capital is protected while stockmarket performance remains reasonable. As well as good returns, well above those of a building society account, and capital protection, they provide short-term flexibility.

This combination of favourable features is why, though guaranteed equity bonds have existed for just over eight years, they have raised about 5bn over the last five years. As far as risk-averse investors are concerned, the capital protection is perhaps the most important feature of a guaranteed equity bond product. Unless the market goes into freefall, the original investment will be returned.

Some guaranteed equity bonds also guarantee the capital gain. Depending on market conditions, investors are offered the opportunity to lock into the growth which has been achieved. This opportunity is usually offered at some point within the final 18 months of the life of the bond.

Many cautious investors who have taken the opportunity to lock in capital gains welcome the security. But the downside is that growth is forgone after the lock-in and, when markets continue to rise, investors may well kick themselves for their caution.

A guaranteed equity bond product works by comparing stock index levels on the start date and the end date. The uplift is calculated on the difference between the two levels. Some products, as mentioned, lock in capital growth while others seek to protect investors from sudden fluctuations in indices during the final six or 12 months of the product&#39s life.

The second is achieved by taking readings at fixed intervals throughout the final period and calculating the final fix as an average of those readings. This back-end averaging is designed to protect gains made during the life of the product although it cannot guard against a sustained decrease during the final period.

Some investors who are attracted and satisfied by the risk-free format are happy to build their investment portfolios around such products. For others, guaranteed equity bonds are just the first step in building an investment portfolio, as the experience gives them the confidence to invest in a variety of higher-risk products.

Abbey National Treasury Services offers a guaranteed equity bond, administered by NDF Administration, with returns underpinned by a high level of capital protection in an investment plan. The extra-income & growth plan is set to launch on June 1 and closes on July 21. It provides tax-free growth of 31 per cent for a basic-rate taxpayer, 38.75 per cent gross or an income of 10.25 per cent, which is equivalent to 11.53 per cent gross for a basic-rate taxpayer a year and 2.37 per cent quarterly, corresponding to 2.67 per cent gross for a basic-rate taxpayer.

There are no initial or annual charges on the plan, so income and growth remain intact over the three-year term. Investors are given the option of either anannual income of 10.25 per cent (11.53 per cent gross), a quarterly income of 2.37 per cent (2.67 per cent gross), or capital growth 31 per cent (38.75 per cent).

Investors should warm to the added advantagethat at the end of the investment term, 100 per cent of the capital is returned, provided the Dow Jones Euro Stoxx 50 Index does not fall by more than 25 per cent of the initial level.

Unfortunately, some investors are put off by thefact that guaranteed equity bonds are hedged, many being linked to a number of indices to spread risk.

Talk of derivatives and hedge funds usually brings to mind high finance and Champagne-guzzling City boys playing fast and loose with other people&#39s money. It is no surprise that most private investors are happy to steer clear of derivatives as well as options, swaps, hedges and all the other suspicious buzzwords of high finance.

However, derivatives provide the foundation of most protected or guaranteed funds, where they are used to provide security against potential stockmarket reversals. Investors scared away from such products because of the perceived risk may well not realise that not only are they missing out on significant returns but their equity Isa may well prove to be a riskier investment than a guaranteed equity bond.

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