With all the volatility that has plagued stock markets over the past few months, the idea of investments that guarantee your capital or, at the very least, undertake to protect the value of at least part of it, may seem attractive. But if you think there is a catch, you may well be right. Investors need to be aware of just what that guarantee, or degree of capital protection, will cost you.

Firstly, there is a difference between the two. When you read the word ‘guarantee’ on
an investment, it means that your initial capital investment will be completely guaranteed and, in addition, you may get some return on top. But the catch, as such, is that you will probably be able to get a better return elsewhere.

When you see ‘capital protection’, it is time to tread more carefully. The capital protection may be limited and, as a rule of thumb, the higher the return, the more at risk
your initial capital will be.

Security costs
‘If you are guaranteeing some form of return, then that guarantee comes with a cost, and that cost is going to be the lower potential for performance or it is going to be higher charges,’ says Danny Cox, head of financial practitioners at Hargreaves Lansdown. ‘If you want to have something that will offer either a guarantee of your capital or some income, it is going to cost you somewhere along the line. Investors need to have their eyes open to the fact that they will not necessarily be enjoying the full upside of the investment.’

The main options for investors seeking to limit their downside risks take the form of guaranteed bonds, which can be structured to deliver either income or growth returns, and capital-protected products, which also take the form of bonds but can be structured as investment funds. Within each type of investment vehicle there are choices to be made in terms of the security of your investment, the return that you get and the tax you will pay.

One of the safest ways to invest is in National Savings & Investment (NS&I) products, which have the security of the government behind them. The return of capital and the interest rate advertised are regarded as safe because the money is guaranteed. If you opt for an index-linked bond you will get an interest rate that is above inflation and your capital back, but you will have to lock your money in for between three to five years.

Currently, the sort of rates you can expect range from 2.9 per cent AER for tax-free
fixed interest savings certificates to 4.05 per cent gross for a five-year guaranteed growth bond. The most recent launch is the NS&I guaranteed equity bond, offering growth potential while keeping your capital secure. The gross return matches the growth of the FTSE 100 index over a five-year investment term, up to a maximum of 70 per cent. If the FTSE falls, you will get your original investment back in full.

The returns are subject to averaging and are liable to income tax when the bonds mature. It has to be borne in mind that there is often a deadline for investing in
such bonds, especially when the product is fully subscribed, so if you like the look of such a bond you should not dither too long.

Securing your income
When it comes to guaranteed income bonds (GIBs) from other providers, there is not a massive choice. Those in the market include Cardiff Pinnacle, Abbey, AIG, Countrywide and Lincoln. Rates begin at 3.17 per cent for basic-rate taxpayers or 3.39 per cent for higher-rate taxpayers on a two-year bond from AIG for investments up to £14,999. They go up to 5.45 per cent gross for basic-rate taxpayers or 5.81 per cent for higher-rate taxpayers on investments of between £100,000
to £249,000.

It will, of course, be noted that higher interest could be achieved with bank or building society deposit accounts or even cash-invested individual savings accounts (ISAs). But for many savers the Northern Rock debacle raised senses acutely to the issue
of compensation.

A key point to remember with cash ISAs is that the limit is £3,000, or £3,200 after 6 April. For investors with larger sums, that amount will only scratch the surface of what they want to invest.Colin Jackson, managing director of Baronsworth, concedes that unflattering comparisons can be made to rates available on some deposit accounts, but adds a warning over compensation.

‘Northern Rock has scared people to death because the cap for the compensation scheme for deposit takers (i.e. banks and building societies) is £35,000. If someone put £100,000 in with a deposit taker and it went bust, they could lose all their money bar £35,000. For those who want total security they should not put more than £35,000 with any deposit taker,’ he says.

With GIBs, the level of compensation is very different. Jackson adds, ‘We have clients
who put millions into GIBs. They could get a slightly higher interest rate elsewhere, but they want the comfort of knowing that, if something terrible happens they are covered 100 per cent for the first £2,000 and 90 per cent thereafter up to whatever figure they have put in.

If you are a non-taxpayer, GIBs are no good for you because you can’t reclaim the tax. If you have a large sum of money and you are a taxpayer, they are worth looking at.’

Taxing questions
Which brings us to tax considerations. ‘With banks and building societies, if you are a taxpayer you are paid net of basic-rate tax,’ says Jackson.

‘If you are a higher-rate taxpayer, you are liable for another 20 per cent tax calculated on the gross figure. With GIBs, you get the money net of basic-rate tax. If you are a higher taxpayer you have to pay an additional 20 per cent but it is calculated on the net figure so, as a higher-rate taxpayer, you pay less tax.’

Capital-protected investments are known as ‘structured products’, usually bonds matched to equity indices. The level of capital guarantee can vary and you will need to check the small print as to how the return could impact on
the security of your capital.

Cox says that while he is always happy to recommend GIBs, he is not so sure about some of the growth products. He says, ‘The ones I am not happy about are the new wave of GIBs that guarantee you will be able to draw five per cent of your original capital for your lifetime, egardless of what happens to investment conditions. The cost of the nderlying guarantee comes in two formats: on the one hand, the charges are quite high and you have very little investment choice and can be locked into a heavy weighting of fixed-interest investments.

‘The likelihood is that the equity markets are going to push forward at some stage. The opportunity cost of having so much in fixed interest is that pretty much the only performance you are going to get is that five per cent. It is going to be very stodgy.’

Middle of the road
Cox says that structured products are designed for the average investor who likes the idea of a better return than they think they can get in cash but, on the other hand, want some form of lower risk.

He continues, ‘The reality is that most structured products are not very good value for money, and even the IFAs selling them do not really understand what is under the bonnet. You also have issues in the derivatives market where it is all falling apart because of the credit crunch. We had a whole series of structured products that failed when the market crashed around the tech boom. You have the potential, because of the credit crunch and the issues affecting the derivatives market, to get a similar thing happening again.

‘It is much better for investors to go into something with their eyes open and when they know they can get out quickly if they want to, but they need to understand the risks of
the market.’

If you are concerned about tying your money in for any length of time, an alternative
form of structured products worth looking at are investment notes. Fundamentally, investment notes are a structured listed product with a defined term (usually five or six years). The key difference from more general structured products is that the investor does not have to hold it for the full term. They are quoted on the LSE and are priced daily, so the theory is that at any point in time you can buy or sell them.

Another key difference is the way the capital protection works. ‘The capital protection
is set at the issue price, so if you are buying in the primary market you are going to be
fully protected,’ says Catherine Penney, director of Barclays Stockbrokers. ‘If you are
buying in the secondary market, you may not have your full investment protected
or potentially, if you buy at a discount, you may actually have capital protection at a higher level than you have initially invested in.’

The attraction of investment notes tends to be the range of underlying investments, which can be the typical FTSE 100 protected products. But, as Penney explains, Barclays offers notes investing in commodities, baskets of financial services companies, property indices and a China bond offering 125 per cent of the performance of the Chinese market. The more adventurous the underlying index, the greater the impact this could have on your investment.

‘We try to bring investors access to markets they may not normally be investing in, with the added benefit of some capital protected,’ says Penney. ‘Some notes offer full capital protection, usually on the more mainstream products.’

The costs of flexibility
There is a price to pay for being able to trade in and out. The benefit of capital protection fully applies only if you hold the notes to maturity. If you sell halfway through, the capital return will be at a market price.

Penney explains, ‘If the initial price is 100p per unit and you sell, you could get a price below 100p or you could get a price well over 100p. If you were buying, however, you would only be protected at the initial level of capital protection, so you would
be protected at 100p, but may be paying 125p to get into that product in the secondary market.’

For anyone with an eye to some form of guarantee on either capital or return, the key point is to understand what you want from the product. Do you want income or growth? Would you prefer your income monthly, annually or quarterly? Do you want to take a risk with your money and get a better return or no risk at all? If you get no return, but only your money back, will you be happy with that?

‘If you are happy to take the risk in the market then invest in the market. Otherwise look to get your guarantees through things like National Savings,
cash, or those guaranteed income or growth bonds through which you are not exposed to the market,’ says Cox.

‘You can’t have the free lunch of a guarantee and a fantastic return. A proper IFA will help you understand what risk you can take to meet your objectives. If something looks too good to be true it probably is.’