Guaranteed equity bonds are a guaranteed waste of time

Update: read Why you should avoid guaranteed equity bonds for more reasons to avoid GEBs.

The men of the financial services industry are marketing masters; there’s no bad product they can’t make sound good.

Take the guaranteed equity bond, or GEB. The very name suggests it’s the perfect investment: it’s a bond, so it’s safe; it’s guaranteed, so it’s extra safe; but it’s also got equities in it so it’s a little bit racy too. All in all, it appears to offer upside with no downside.

But strip the marketing veneer from most GEBs and they don’t look quite so good.

There’s the current offering from Birmingham Midshires, for instance. It offers a return of 19% over three years as long as the FTSE 100 index doesn’t fall over that period. If the Footsie does fall you get a return of nothing but you do get your original capital back in full. This sounds like a reasonable sort of a deal (so much so that I was only just in time to stop my mother investing in it) but in fact it is truly pathetic.

A 19% return over three years works out at a measly 5.97% a year. But if you put your money in an ordinary savings account today you can get interest of 5.1% a year, more in longer-notice accounts. Is the extra 0.87% really enough to make you want to tie your money up for three years and run the risk of losing money if the Footsie doesn’t rise?

I say losing money because that is exactly what will happen. The issuers of GEBs make a great song and dance out of how you will get your original capital back in full regardless of the state of the market, but you only get it back in nominal terms: if you take inflation into account (at say 2.5%) £ 100 invested today will be worth only £ 92.60 when it is returned to you in three years.

It’s also worth noting that inflation may well rise by much more than 2.5% a year, something that will make many GEBs look even worse value than they do now. Why? Because it pushes up the returns from ordinary savings accounts (you are going to feel pretty silly if savings accounts are offering a risk-free 7% when your money is tied up with Birmingham Midshires at less than 6%); it increases the odds of the Footsie falling (stocks often fall as interest rates rise); and it eats into the purchasing power of any capital you get back. If inflation runs at 3.5% your £ 100 will be worth only £ 89.86 by the end of the bond’s term.

One final gripe I have with the Birmingham Midshires GEB is that it isn’t even giving you real exposure to the racy stuff suggested by the word ‘equity’.

Because, in the words of the brochure, your money is ‘linked to the FTSE 100 rather than invested in it’, you won’t ever get more than 5.97% a year.

The Footsie may break out into the greatest bull market of all time, but your ‘equity’ investment will still go virtually nowhere. I have picked rather on Birmingham Midshires here, but it’s not the only one to offer this utterly useless product. There are plenty more out there, using plenty more tricks to ensure that their providers make more money out of GEBs than you do.

Most use a process called ‘averaging’ to figure out how much you get paid at the end of the bond’s term, something that means (as the blurb from Britannia puts it) that in some cases the ‘end value’ (which sets how much you finally get paid) may be lower than the starting value, ‘even though the FTSE 100 level at the end of the term may be higher than the start value’. Not very encouraging, is it?

Not all GEBs are completely awful. Abbey has launched one that offers 130% of the rise in the FTSE 100 over the next five years, although this is capped at 50%. It also guarantees the return of your capital if it doesn’t rise. This comes with all the drawbacks of your average GEB (you have to tie your money up for years, you don’t get dividends and, if you only get your original capital back, its purchasing power will be eroded by inflation), but relative to other offerings it isn’t too bad: getting 130% means you are compensated to a degree for getting no dividends, and it offers a better potential return than most GEBs.

But I still wouldn’t buy it for my portfolio. I’m wary of complicated products; the more complicated something is the more money its provider is generally making, and GEBs are nothing if not complicated.

To my mind those who are too risk-averse to invest directly in the market should probably stick with savings accounts for now and those who are not should invest via quality investment trusts.

First published in The Sunday Times (28/05/2006)