Why you should avoid guaranteed equity bonds

With guaranteed equity bonds flying off the shelves at moment, should you join the rush? Tim Bennett doesn't think so…

When a product offers 125% of the growth in the FTSE 100 on a £1,000 investment over five years or your money back, my immediate reaction is that it all sounds rather complicated and if it looks too good to be true, there must be a catch. This is the deal offered to investors in the National Savings Bank's guaranteed equity bond (GEB) and it's just one example of a type of product that is flying off the shelves at the moment. But should you join the rush?

There is certainly no lack of choice for GEB enthusiasts just recently Saga joined a growing list of issuers that includes most of the banks and building societies, and even Tesco Finance. So let's take £1,000 and look at why buying a guaranteed equity bond is not as clever as the issuers would have you believe.

Take the NSB product, which is one of the most generous guaranteed bond deals out there. Say you put £1,000 in and the index rises by a healthy 30% over the next five years. You will receive a return of 37.5% (1.25 x 30) and therefore £1,375 back from the NSB at the end of five years. But if the market falls over the next five years, you get your £1,000 back instead. Sounds good, until you realise what you are missing out on while your capital is invested in the bond interest and dividends. Take interest: £1,000 could have been invested in something 100% safe, if a tad duller, such as the National Savings Bank's five-year fixed-interest certificates, paying a guaranteed 3.85% tax free. To a higher-rate taxpayer that's a pre-tax return of around 6.4% (3.85/0.6) per annum, which equates to £1,364 after five years. Slightly less than £1,375, but considerably more than the minimum £1,000 from your GEB should the FTSE fall over the five-year term.

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If you're a less-cautious investor, you could simply have invested the original £1,000 in a range of UK equities, or even a tracker, rather than a GEB. The key is dividends: with a GEB you only get the capital growth over the investment period, whereas a direct-equity investor would also benefit from dividends, which, according to The Daily Telegraph, have accounted for around 30% of the overall return from FTSE 100 stocks over the last five years. Then there's the inflexibility many GEBs set high minimum subscription levels of £3,000, or even £5,000, some are not eligible for Isas (for example, the Saga offering) and most require you to lock up cash for up to five years, with hefty redemption penalties for a mid-term change of heart.

So are they all bad? In truth, there's not much going for them. If you are too worried about capital loss to invest in the stockmarket outright, you'd be better off with a high-interest savings account your capital may be preserved in a GEB, but that doesn't protect it from inflation. And whatever happens, you are unlikely to match the returns that could be had with a balanced portfolio, which can be altered as economic conditions change.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.