Security comes with a price

Demand has risen for market-linked products which guarantee your initial investment

IF YOU were asked whether you would like to invest in a product which offered you the potential to benefit from rising stock markets, but with no risk to your capital, what would you say? It is no surprise that most people would say yes, hence the rise in demand for investment products which are linked to the stock market, but which also guarantee your initial investment.

Having seen much of their investments wiped out on global stock markets over the past two years, investors are appreciating the certainty offered by capital-guaranteed products and tracker bonds. According to Irish Life, over €4 million a week went into its capital-protected bonds in the last six months of 2009 – a 60 per cent increase on the first half of the year.

However, are such products just a technique aimed at improving the bank’s balance sheet and an expensive way to protect your investment, or do such products offer the twin advantage of protecting your capital while also realising stock market gains?

How do they work?

In general, a certain proportion of your initial investment will be invested in a low-risk product – such as a deposit account or fixed income fund – while the rest is given exposure to the stock market. Irish Life’s Protected Advantage Bond, for example, invests in both Irish Government bonds and the Advantage fund, which consists of a mix of shares and fixed interest bonds, while Ulster Bank’s Right Track Bond invests a proportion of your funds in a deposit account, with the remainder tracking a stock market index.

You have to lock away your funds for a fixed period of time, usually between three and six years, and while there is no downside if there is a 100 per cent guarantee, the upside on the investment is capped.

What are the advantages?

The obvious main advantage of investing in such a product is that your initial investment is either fully or partially guaranteed provided you stick with it for the required period of time. Irish Life’s Protected Advantage Bond, for example, guarantees you at least the amount you invested after its 6½-year term, while Bank of Scotland’s Phoenix account also offers a 100 per cent capital guarantee.

Moreover, you can frequently get a minimum return on this money. Bank of Scotland’s product, for example, which had four launches last year and is currently readying its fifth, offers you the higher of either an agreed rate of return (the most recent launch offered 1.75 per cent AER) or 50 per cent of the growth in the Dow Jones EuroStoxx 50 Index provided you locked in for the 5½-year investment term.

Finally, unlike a straight forward deposit account, such products offer the possibility of performing better than the minimum return on offer, linked as they are to a stock market index such as the aforementioned DJ EuroStoxx 50.

Are there any disadvantages?

With most things in life, if you’re looking for a guarantee on anything it comes at a price, and the same is true of capital-guaranteed products. In most cases, you will sacrifice the possibility of a higher return for this guarantee so one of the main disadvantages of investing in such a product, rather than the stock market itself, is the limited potential for growth.

As mentioned, Bank of Scotland offers just 50 per cent of the growth in the index it tracks, while Bank of Ireland will give a maximum annual return of 7.6 per cent on its Secure Plus product, while one of the options Ulster Bank’s RightTrack bond offers is 60 per cent participation in any growth of the RBS European Balanced Sector Index for 60 per cent of your investment.

So in many cases you may emerge at the end of the investment period with either just the amount you put in or a return similar to that offered by a deposit account.

Another disadvantage is that products have a fixed term which means you can’t choose to liquidate at a good time in the markets but are forced to do so at a certain date. Again, this may limit potential growth.

Although many of the products base the final performance of the market they are tracking over a period of time, rather than one day, such an approach may still work against the investor. For example, the return of Bank of Ireland’s Secure Advantage is based on the closing values of the indices it tracks over the final 12 months of the investment term, as is Bank of Scotland’s Phoenix. While this will reduce the impact of sudden falls of the relevant indices prior to maturity, it may also adversely impact performance if markets rise just before encashment.

In addition, it can be very difficult to work out the fee structure of such products. In many cases it is incorporated into the structure of the product – for example, there are no charges on the Bank of Scotland’s Phoenix product. On the other hand, if fees do apply they can be hefty – Irish Life’s Protected Advantage Bond has a 1.95 per cent annual charge, for example.

Who provides the capital guarantee?

In some cases institutions pass on the responsibility for the guarantee to a third party, so the financial strength of the guarantor should be a key consideration for investors. For example, failed bank Lehman Brothers used to provide the guarantee on some of Irish Life’s tracker products.

How do such products compare to other investments?

Take the example of someone who invests €10,000 in a five-year product which offers 100 per cent capital security, and 60 per cent of the rise in the FTSE100 index.

If, at the end of the term, the index has risen by 30 per cent, your investment will have grown to €13,000.

However, as your gain is capped at 60 per cent you will only be entitled to a profit of €1,800 or 18 per cent over the term of the investment.

So, when you pay your exit tax of 28 per cent you will walk away with a total of €11,296. This works out at an annual rate of return of just 2.7 per cent a year after tax.

If you had simply put your money in a deposit account paying 3 per cent a year you would have come out with almost €11,600, before DIRT, while if you had invested directly in a fund tracking the FTSE 100, you would have over €13,000 before taxes and charges.

If, on the other hand, the FTSE 100 had a negative outcome after the five-year period, falling by 10 per cent, you would still walk away with your €10,000. While significantly less than if you had kept your funds on deposit, it does mean that you won’t suffer the loss you would have incurred if you had invested directly in a fund.

Are there any other negatives?

Unlike investing directly in stocks and shares, investors in guaranteed market-linked products don’t benefit from dividend income, which will hit potential returns

Tracker bonds are charged a higher level of DIRT, which means that interest earned is subject to DIRT plus 3 per cent, or 28 per cent in total.

They are not very transparent, which makes it difficult to compare products

Unlike regular investment funds, you must lock in your investment for a fixed period, and if you withdraw your money before the term ends you will likely incur penalties.

Irish Life, for example, charges a penalty of up to 5 per cent depending on when you cash in.