A guaranteed gamble

Following the Nick Leeson fiasco, the word "derivative" is liable to bring investors out in a cold sweat. But correctly used, derivatives can be very useful either for betting on profits or protecting against losses when stock or bond markets move in a volatile way. Indeed, the rash of bonds, offering steady income or promises of capital growth based on how stock markets perform, which are being hawked by an increasing number of companies, depend on derivative instruments to work.

But these investments are attracting criticism from several quarters.

The problem with these bonds is not that they do not work, rather the way they have been advertised and sold. Specifically, there are concerns that traditional building society investors may have been unfairly seduced by "guarantees" of high tax-paid income without being adequately aware that their capital may be at risk. That said, for someone who understands exactly what is on offer and is happy with the risks, there are some deals around which are potentially very attractive.

There are three main types, all of which involve a small part of what you invest being put aside to take a bet against the movement of stock markets over periods of up to six years.

The recent offering from Abbey Life guarantees to pay back your money, say pounds 10,000, after six years plus the greater of a 40 per cent bonus or 50 per cent of any rise in the FTSE 100 over the period. The basis of calculating the stock market's performance is without dividends. As the reinvestment of dividend income often fuels much of the growth in a portfolio this may seem mean. But by not passing on those monies the issuing company can buy derivative instruments to guarantee the 40 per cent minimum profit even if the market crashes.

Legal & General's Election Bond is variation on the same theme. It puts the bulk of the money on deposit to accumulate and the balance is used to buy options to enhance any rise in the stock market by 40 per cent. The capital is repaid in full only after five years, there is no dividend income in the meantime and any gains are based on a four-year period, because the base and the finishing points are averaged over the first and last years.

Swiss Life's offer, available until the end of the month, is typical of option two: your money will be returned at the end of the period with a bonus of 60 per cent of the original investment, but only if the FTSE 100 and the Standard and Poor's indices are no lower at the end of the investment period than at the start.

David Wright, financial services director of Croydon-based independent advisers Johnstone Douglas, said: "At first sight this may seem to the uninitiated like a better deal - but only because the numbers are bigger. Cynics might question why the investor has to punt on two indices rather than one. Swiss Life says that if they fall by 5 per cent or more investors will at least get their original money back, and there is a sliding scale for payouts if the index falls between 0 per cent and 5 per cent. But if prices fall 6 per cent or more, then the whole 60 per cent bonus certainly disappears."

Swiss Life offers an income option whereby the investor can trade in the prospective 60 per cent capital bonus for an annual income throughout the period of 10.75 per cent net of basic rate tax. But if the stock markets' performance fails to strike, the amount of capital returned at the end could be severely depleted. This is because the "guarantee" of paying back no less than the original capital includes any income paid out. So if an investment of pounds 10,000 yielded pounds 1,075 for five years (pounds 5,250) and one or both of the relevant indices fell by more than 5 per cent, all Swiss Life would pay back at the end would be the balance of the original pounds 10,000. In other words pounds 4,750.

Another variation on offer from Eurolife pays 10.3 per cent net income on investments up to pounds 25,000, or a 72 per cent bonus after six years, provided neither the FTSE nor the Dow Jones falls over that period. Six years is a better bet than five, given the long-term trend of markets to rise, but if either falls all you get back is your original capital, less any income you took.

In each variant, the key feature is whether or not you regard it as acceptable to take a gamble over the medium term on UK or US stock markets - or in many cases both. For some, this may be acceptable. But if there is any chance you may need to come out before the end of the pre-determined term these bonds should be avoided at all costs. Because of the way the derivative instruments work, surrender values, mid-term, can range from extremely disappointing to downright horrendous. If you get back more than half what you invested in circumstances of early surrender you may be doing very well indeed.

Yet despite the potential drawbacks, tranches of these stock market-related investment bonds are being released in ever growing numbers. John Owen, from Nottingham advisers, the Building Society and Pensions Shop, said: "The closing date for each issued bond can act as a spur to many people to `buy while stocks last', but this is not the way to approach it. As soon as one offer closes another will open, so there is no need to be panicked into buying."

Scottish Life International have yet another option available until 31 January. For each individual year that the US and UK markets do not fall, up to six years, 17 per cent of the original investment will be added to the investment. The total possible value after six years, therefore, is 202 per cent of what goes in. And whatever happens to stock markets the minimum return is 134 per cent of the original. The catch, if it can be called that, is that the maximum return depends on the index for each individual year remaining stable or increasing.

Earlier this month Financial Assurance launched a product paying out an income of 8.25 per cent net of basic rate tax and guaranteeing a full return of capital as long as the FTSE 100 and the S&P 500 do not fall by more than 20 per cent over five and a half years. The penalty for performance being worse than the necessary "striking point" will be the usual loss of around 50 per cent of the underlying capital, but at least this particular offer combines a regular return currently far in excess of most deposit accounts with a reasonable safety net for the capital.

Before taking up any offer it is vital to understand the small print. A few hours with an independent adviser specialising in this complex area could be the best investment of all.