These bonds couldn't lose - until they did

Evidence of mis-selling in the financial services indus- try is becoming more common as stock markets struggle and various products – endowments, pensions, split-capital trusts – fail to deliver the returns rashly promised by numerous salesmen. In the heyday of the prolonged bull market, when many of these products were sold, it seemed inconceivable that shares wouldn't continue to be buoyant. Even if there was a blip, it wouldn't last long.

But nearly three years into a stock market downturn, there is still no end of the bear market in sight. As a result, many investments are underperforming. The latest products to cause concern are "precipice bonds", otherwise known as high-income bonds, stock market income bonds, premier bonds or extra income and growth plans.

Lloyds TSB, which sold high-income bonds under its Scottish Widows brand, is set to become the first financial institution to be fined – hundreds of thousands of pounds – for not explaining clearly enough how such products are at risk in falling markets.

High-income bonds prom- ised investors just that – in some cases as much as 10 per cent – on the lump sums they put in, plus all their capital back at the end of the investment term, usually three or five years. Provided that the markets did not fall too far.

No guarantees were given that investors would get their capital back; its return depended on the index or shares that the bonds were linked to not falling over the lifetime of the investment. A number of bonds carried a safety net, allowing the index to fall up to 20 or 30 per cent before investors lost any capital.

The problem was that these precipice bonds exploited derivative contracts linked to a stock market index or basket of specific shares. The only way the sums promised could be achieved was to invest in high-risk stocks. And as the market slumped, the stocks chosen became even higher risk in order to maintain the yield that investors demanded.

Additionally, the indices chosen became ever more risky, including the Nasdaq 100 index of hi-tech stocks. Some providers also reduced the number of shares to which the bonds' performance was linked, further increasing the risk.

Launched in the early 1990s, high-income bonds became very popular about six years ago as interest rates fell and investors were attracted by the bonds' much sexier rates. The Financial Services Authority (FSA), which in December 1999 urged consumers to think carefully about the level of risk they were willing to accept before buying high-income products, believes 250,000 people invested £5bn in them. The average age of investors in precipice bonds is 60-plus, according to the FSA, and with four such products launched each month, it is feared that many retirees are buying them from a fixed amount of savings in order to generate income.

Many bonds maturing this year were bought at the height of the stock market bubble, so the index or shares they are linked to have fallen dramatically. Thousands of investors risk losing as much as 50 per cent of their capital as these products mature, even though much of the literature accompanying the bonds suggested they were low risk.

"Retirees are a particularly vulnerable group, as many find themselves with large lump sums to invest," says an FSA spokesman. "They may see the word 'bond' and assume the product offers a promise that their money is safe."

The FSA is not just breathing down the neck of Lloyds TSB, which no longer offers precipice bonds. HSBC, Abbey National and a number of independent financial advisers (IFAs) are finding themselves in the same situation. They will have to prove that the risks were spelt out and that the bonds were appropriate investments to sell to older consumers. The FSA will also want to know whether some of the precipice bonds were excessively risky.

Unlike equity income funds (see page 17), which invest in a portfolio of shares paying healthy dividends and aim for longer-term growth while providing income, there is nothing cautious about precipice bonds. Unfortunately, there is little those already invested in them can do because there will be penalties for encashing them early.

"These investors shouldn't do anything," warns Anna Bowes, savings and investment manager at IFA Chase de Vere. "If you've got years to go until your bond matures, you are in a much better position than those whose bonds are maturing now because you have some time for the markets to recover. All you can do is leave them running and hope this is what happens."

Once their precipice bonds mature, investors could try a new innovation called a "recovery growth plan". Ms Bowes recommends Key Data's product, which gives 200 per cent of the upside of the FTSE with a protected downside of 50 per cent. While the fund is not guaranteed and the market could well fall, she believes it is unlikely to fall a further 50 per cent from its current low.

"This fund should help recoup losses more quickly, and given that it has a five-year term, the markets should improve during that time," she says. "However, it provides no income so won't be suitable for people in retirement who rely on this."

While it may be too late for those already invested in high-income bonds, there is a valuable lesson here for everyone: be aware of the risks involved in whatever product you opt for. The FSA has published a factsheet that spells out some of the dangers.

For the FSA factsheet, 'High Income Products – make sure you understand the risks', go to www.fsa.gov.uk/consumer or call the FSA's consumer helpline on 0845 606 1234.