Jonathan Davis: The perils of 'precipice' bonds

After my comments about the dangers of "precipice" bonds, a reader has sent me an example of an investment he made in just such an instrument, one he regrets having put his money in. The bond was among high income and growth plans by GE Life (motto "We bring good things to life") and which our reader bought as an Isa through a well-known independent financial adviser.

Many of these bonds have been caught in tumbling stock markets. Patrick Connolly, a director of the IFA Chartwell Investments, who studied precipice bonds, says investors stand to lose at least half their money and in some cases may lose everything.

The marketing material the reader sent me illustrates how these potentially lethal products were sold at the time. The marketing material dates from an offer that ended in May 2001, after the peak of the stock market bubble, but still little more than a year into the great bear market.

Under the heading Why invest in the High Income and Growth Plan IV?, the brochure lists seven main reasons as bullet points. The first two are the options facing investors, "10.25 per cent income per annum OR 33 per cent growth". The next four are "a significantly higher return than you might expect from a fixed-term savings account"; "option of taking your income monthly"; "investment period of three years and two months"; "tax-free advantages, including £7,000 Isa wrapper for 2001/2002", and finally "a 20 per cent safety zone".

The next paragraph reads: "Capital return is linked to the Dow Jones Euro Stoxx 50 Index, an index of leading blue-chip companies in the eurozone of continental Europe. Since the index was introduced in January 1992, full capital would have been returned on 100 per cent of all similar periods using the same investment formula." Then in much smaller letters comes the famous rubric, "Past performance is not necessarily a guide to future performance".

Then comes a statement: "In our opinion, in Europe, rationalisation within companies leading to greater efficiency, the successful war against inflation and greater individual investment in shares, indicate that the Eurostoxx 50 Index should perform well in the next few years." So far, in other words, this is a classic example of the kind of weasel words and fuzzy logic that cause such trouble in financial product marketing.

Note how "return" and "income" are carefully used as meaning the same thing when they are clearly not the same in this context. Note also the spurious rationalisation for the vague but meaningless prediction that the index "should perform well"; and the use of a classic warm and friendly sounding phrase ("a 20 per cent safety zone") to describe something that is not about safety, at least as ordinary investors are likely to interpret it.

What this refers to is the fact that the market has to fall by 20 per cent from its initial level before the investor's capital is threatened. When coupled with the statement that this threshold would not have been breached at any time in the index's short history, this is clearly designed to provide the impression that it is an extremely improbable event (something that any student of financial history and theory would tell you does not follow from the simple statement of historical fact).

There is nothing anywhere that, taken in isolation, can be said to be factually incorrect on a narrow interpretation. On the next page, the brochure clearly spells out the conditions in which the investor will not get his capital back. It also explains how, if the market falls by more than 30 per cent, the investor stands to lose at least 2 per cent of his total investment for every 1 per cent the index is below the starting level when the plan matures in June 2004.

With the Eurostoxx index standing at 2280, against its level of 4400 when the reader made his investment, he stands to get nothing back, though if the index does recover to its starting level, he will get all his capital plus the 33 per cent growth he opted for at the outset. How likely is it that the market will roughly double between now and next summer? It is possible, but not probable. But if you input the range of possible outcomes into a spreadsheet, and plot them as a graph, you end up looking at a graphical representation of an option trading strategy that few if any investors would rationally want to adopt. In effect, while your potential gain is limited to 33 per cent whatever the market does, you stand to lose two-thirds of your money if the market ends more than 33 per cent below its starting level, and all your money if it falls by 50 per cent or more.

You can be sure the guy on the other side of the deal has taken much the better of the bargain. His downside risks are small (and will have been hedged) and his upside is theoretically unlimited. It is hard to see how any adviser could advise his clients to put their money into such an inappropriate product. The adviser's best advice would surely have been to forbid any client from going anywhere near such a "weapon of potential wealth destruction". The guff in the brochure, with its crafty elisions and circumlocutions, is secondary to that fundamental point.

Of course, no self-respecting Chancellor of the Exchequer would try to sell you such a dud now, would he? There is no doubt Gordon Brown's child trust fund, announced in this week's Budget, stems from a laudable desire to put capital into the hands of less well-off children as they approach adulthood. It was amusing to see the Chancellor and the Treasury spouting projections based on historic rates of return to illustrate what the bonds (£250 for better-off families, £500 for less well-off) might be worth in 18 years.

A return of 5 per cent in real terms would be worth having. A pity that longer-dated Government bonds, which take no account of inflation, are yielding only 4.5 per cent, and inflation-linked bonds can offer only half the 5 per cent real return the Chancellor mentioned. To achieve that, the bonds will have to be linked to the equity markets, and they are not controlled by Chancellors. The risks for the insentient babies due for a windfall on their 18th birthdays are that along the way the original good intentions will be swept away by political or regulatory interference. A good idea, but the devil will be in the detail.

davisbiz@aol.com