Risky world of the high-income bond

Even with low interest rates, investors can still earn an annual income of nearly 11 per cent gross, almost five points higher than the Bank of England base rate. It is hardly surprising many income-hungry investors are tempted by high headline figures. Look at the alternatives.

Guaranteed income bonds, of between one and 10 years, may present no risk to your capital but their returns look sorry by comparison. AIG Life pays 5.30 net of basic rate tax on its one-year bond on balances of £5,000. Countrywide Assured pays 5.45 per cent net on balances of £10,000 on its five-year bond. These are the ones that top the best buy tables.

This kind of rate has forced income seekers into the arms of more risky investments, high-income corporate bonds and high-income bonds. Many of these offer rates make guaranteed income bonds look feeble. But the higher return comes at a price - the Financial Services Authority recently warned investors of the risks.

Some of the highest income rates are paid by high-income bonds. These pay a guaranteed income for a set term, but to get your hands on some attractive rates you have to put your capital on the line.

The Scottish Life International Income & Growth Bonus Bond, an offshore bond that closes at the end of March, pays a guaranteed income of 10.55 per cent gross. The term is three years and two months, after which all your capital will be returned, provided the index it is attached to, the Eurostoxx 50 index, has not fallen by more than 27 per cent at any time during the investment term.

If it does fall below that, you will lose part of your original investment, unless the index has returned to its original "strike level" when the bond matures.

Should the index fall more than 27 per cent at some stage and ends up 10 per cent below its strike level when the bond expires, an initial capital investment of, say, £15,000 will be eroded to £13,500. The further the index has fallen, the less capital you get back.

The Scottish Mutual Income Bond guarantees 8 per cent net income over three years and returns your original capital if the Eurostoxx 50 does not fall by more than 20 per cent over the averaging period.

The Canada Life High Income Bond (series 3) tracks a more volatile index, the NASDAQ-100, which follows US technology companies. The offshore bond pays 10.5 per cent gross annually for three years and provided the index has not fallen by more than 20 per cent on its expiry date, you get your full capital back.

Patrick Connelly, director of Chartwell Asset Management, says high-income bonds prove a basic rule of investment. If you want higher rewards, you must take higher risks.

"Whenever you leave the safety of a building society or guaranteed income bond there is a risk. The higher the yield, the higher the risk. You see billboards plugging income products returning 8 or 9 per cent or more, but these never mention the underlying danger to your capital."

High-income bonds can guarantee high rates because if their chosen index falls during the term of the bond, the income comes out of your original capital investment. In effect, you could end up paying yourself. "This is fine if you understand the risk you are taking. My concern is that many people do not."

The risk will partly depend on the index tracked. The Eurostoxx 50 index, which tracks the largest 50 companies in Europe, looks a safer bet than the NASDAQ-100, which follows volatile technology stocks.

Mr Connelly says that wherever you see an interest rate higher than anything available from a bank or building society, you must assume there is a risk. Even corporate bonds.

They are loans issued by companies to raise money for their expansion. They pay a fixed rate of interest on a lump sum and are traded on the stock market. The risk you take is that the company may default on payments, but this can be reduced by spreading your money across a variety of companies using a corporate bond fund.

Many funds are low risk, such as M & G Corporate Bond, because they invest in blue chip companies less likely to default on loans. But these pay interest rates between 5 to 6 per cent. Investors wanting a higher return have been drawn to high-income corporate bonds.

These are higher risk, because they invest in sub-investment grade bonds, issued by less-established companies with a higher risk of default. Investors, lulled by the corporate bond tag, learned the hard way. "Many wised up over the past 18 months because most bonds have gone down in value," says Mr Connelly. "Despite the high rates, demand for corporate bonds is falling."

Schroder Monthly High Income pays an estimated gross annual income of 8.75 per cent. Norwich Union Higher Income Plus ISA pays 8 per cent net of all charges, as does Standard Life High Income Fund. These are based on current yields, which means they could fall.

Martyn Page, head of research at financial advice network Countrywide, says when selecting a corporate bond you are choosing between a high income, or protecting your original capital and giving it the opportunity to grow. "The more income you receive, the more your capital will be eroded. It really is as simple as that."

Canada Life High Income Bond (series 3) 10.5% gross guaranteed 020 7734 6841

Scottish Life International Income & Growth Bonus Bond 10.55% gross guaranteed Only through IFAs

Scottish Mutual Income Bond 8% net guaranteed Only through IFAs

Norwich Union Higher Income Plus ISA 8% net (variable)0845 300 3344

Schroders Monthly High Income 8.75% gross (variable) 0800 526 535

Standard Life High Income Fund 8% net net (variable) 0800 333353