How to play it safe, and make it pay

After yet another week of turbulent stock markets, investors may be forgiven for thinking there is little hope of decent returns on their money without risking the lot. But you can avoid the stock market fallout, and still make a respectable gain.

After yet another week of turbulent stock markets, investors may be forgiven for thinking there is little hope of decent returns on their money without risking the lot. But you can avoid the stock market fallout, and still make a respectable gain.

The first and safest bolthole is the deposit account. The top-payers offer gross rates from 4.1 per cent to 4.45 per cent, but you often have to leave your cash on deposit for at least five years.

The best deposit rates tend to be for mini-cash Isa accounts, where the interest is tax free, but you are restricted to investing a maximum of £3,000.

Other tax-free deposit options are provided by National Savings & Investments (NS&I), which have the added security attraction of being government-backed. The rate on the two-year, fixed-interest savings certificate is 2.4 per cent. This is tax-free and guaranteed.

After basic deposit accounts, there are gilts, corporate bond funds, guaranteed growth and income bonds and a range of protected investments available for those who prefer caution. But in each case, there is always some degree of risk.

Unlike deposits, it is possible to suffer a capital loss by investing in gilts and corporate bonds. Most pay a rate of interest that is fixed, so the price will tend to fall as rates rise. But gilts are bonds issued by the Government, which is unlikely to go bust, and this means their price is unlikely to fall far. The present high gilt prices show the market demands a big premium for such certainty.

Corporate bonds are issued by companies, and their risk depends on the perceived credit-worthiness of that company. In general, the worse the credit risk, the higher the rate offered on the bond. Fixed-interest prices have risen so much, though, that the main threat to investor capital is from a rise in interest rates.

Protected bonds have attracted safety-seeking investors, where the return is linked to stock market growth. Many investors have piled in on the assumption they would get back 100 per cent of capital if all else failed. What they may not realise is that this is predicated on the stock market not falling below a certain level, as described by Jonathan Davis on page 7.

Many products now have unambiguous capital-back guarantees, coupled with options to disinvest if the markets grow a certain amount. Legal & General and Premier Asset Management offer bonds that guarantee 100 per cent return of capital, whatever happens to the stock market. Maximum growth on the Legal & General bond is 55 per cent of FTSE growth over the five and a half year term, Premier's bond offers 100 per cent of the growth over six years. Investors should note their bond will mature early if 21 per cent, 36 per cent and 55 per cent growth is achieved after three, four and five years, respectively. This allows Premier to advertise the 100 per cent rate with a limited chance of having to pay it.

A recent entrant has been the Government-backed, investor safe haven NS&I, with its guaranteed equity bond. This offers 100 per cent capital protection over five years with up to 60 per cent of FTSE 100 growth over the period.

"The National Savings one is safest because it is underwritten by the Government, but there is a nasty tax sting in the tail because the return is subject to income tax," Simon Farrant, at the independent financial adviser Towry Law, says. "The Legal & General bond is likely to provide a higher return after tax."

These protected bonds offer some degree of capital protection, but there are fully guaranteed income and growth bonds, that are written under life insurance legislation.

They include a guarantee of capital back, with a fixed growth or income rate. The underlying investment will be gilts, corporate bonds or Eurobonds. A bond survey from the independent financial adviser Baronsworth shows income rates ranging from 2.8 per cent to 3.3 per cent. Rates on growth bonds range from 2.8 per cent over one year to 18 per cent over five. Guaranteed income and growth bonds also give investors a higher level of protection than deposits or other investments from the Financial Services Compensation Scheme (FSCS). These bonds are issued by UK life companies and pay net of basic rate tax. Unlike the protected bonds, these guaranteed income and growth bonds are not Isa-able, because they require a minimum investment of £5,000, above the Isa life assurance threshold.

The problem for most investors is that by avoiding any form of equity-linked product, they may find it very expensive to buy their way back in if and when the market turns. But there are products available that allow you some protection against capital loss while allowing exposure to gains.

An example is the Close Fund Management range of Escalator funds. They track indices and lock in growth every quarter, using options. The Escalator 100 Fund, which tracks the FTSE 100, returned 37 per cent in the seven years and two months since its launch to 14 March 2003, and the FTSE 100 index returned 4 per cent over the same period.

The advantage here over the protected products is that this fund is a unit trust that is traded daily, so you are not locking up your cash, as with the protected bonds. The initial charge is 5 per cent (but you can get it cheaper through a discount broker) and the annual charge is 1 per cent.

'It looks as if I have lost £10,000 on zeros'

Stephen Conley, 57, sold his promotional gifts company six years ago. Determined to live off the proceeds and spend more time playing golf, he was concerned with the possibility of risk in his investments.

As well as putting a large chunk of money into eight rented properties in his local area of Welwyn Garden City in Hertfordshire, Mr Conley left a large sum on deposit and invested the rest. "I have done well with the property. I started buying five years ago, so I have had a lot of growth. For instance, I made 140 per cent profit on a property I sold a year ago."

Mr Conley, who manages his property investments with his wife, has an investment portfolio including with-profits bonds, guaranteed-income bonds and zero-dividend investment trust shares. He says: "I did invest in the zero shares of the St David's investment trust which was managed by Aberdeen Asset Management. It has now basically gone kaput and it looks like I have lost £10,000."

He invested £24,000 in a two-year guaranteed income bond, through his IFA, Baronsworth Investment Services. The bond offers 6 per cent net, paid annually. "I get the capital back and 6 per cent net of basic rate tax," Mr Conley says.

"My wife and I split our income so we are basic-rate taxpayers, meaning the tax on our investment is not very high."