Banks and building societies typically market conventional deposit accounts (guaranteed by the bank...
Banks and building societies typically market conventional deposit accounts (guaranteed by the bank) and guaranteed fixed term bond issues, essentially a deposit account with a link to a possible equity return. Somewhat more extensive are the life assurance company fixed term products that offer a capital guarantee with equity upside in a wide range of designs with periods of up to six years, some beyond.
Both sets of products are fixed term and may be correctly described as guaranteed. The capital guarantee is explicitly offered by the provider, and no third party/counter party risk is devolved on the policyholder. The investment is as safe as the company offering the product and, with a specifically branded AAA bank or life office, the investment can be considered to carry a maximum guarantee.
Rolling funds are provided by life assurance companies as quarterly (or annual) lock-in stock market bonds in many different variations and a multitude of "wrappers". These bonds exploit index performance over a rolling quarterly cycle and are characterised by features such as investment periods, lock-ins, averaging and ratcheting. They can be a valuable addition to any portfolio, enabling an investor to tune his products exactly to his risk profile. The above products use derivatives to provide efficiently stock market-linked. In each case, a fixed-interest deposit of some kind provides the minimum guarantee and call options the growth element.
Unit trust providers offer similar products but with the investment provided in a unit trust or trust portfolio rather than a life fund. The security comes from the use of put options. While this could be called a "guaranteed" product, the regulatory environment applying to the marketing of unit trusts only allows them to be described as "protected". Rather than using options aggressively to exploit an anticipated rising market performance, unit trust vehicles use them defensively to build a floor below which the value of the investment will not fall. A provider may say that the unit price will not be less than 95% of investment value in one year's time and then purchase put options to hedge that position.
This form of product has advantages for active investors who want to buy and sell on a daily basis rather than the quarterly period of the rolling funds. The product appeals to active investors and those who are more comfortable with unit trusts than other products.
There are, however, quite tough constraints on this style of product set by the regulators. First, they can only be described as protected products, not guaranteed as with the rolling funds described above. Secondly, trust managers may only buy put options up to a small percentage of their fund (currently 10%) and only use them defensively. These limits reflect the active nature of the investment and are devices to prevent investors suffering heavy losses if the use of the put options is unwise and/or over-extensive.
In this situation, managers are sometimes forced to sell options on disadvantageous terms in order to return the size of the option holding to below 10%, which could cause the fund to perform even more badly.
There are some other products to be treated with care. One is a range of investments that may be described by their providers as secure. These products are not guaranteed and are simply packaged along with a phrase stating that the investments are with "a credit-worthy bank", normally named in the small print. This approach enables the provider to avoid holding additional capital, the price of a true guarantee, and allows it to pay a higher return to investors. Such investors are exposed to risk from two sources: the provider and the bank. Alternatively, a fully credit-worthy AAA bank provides full security and is preferable to investors averse to risk.
Another problem area is the so-called precipice bond, which has now been modified but can still be found in some forms. These are essentially high income bonds that offer investors around 10% a year for five years, with income paid out of potential growth. What investors could find is that, on redemption, growth is inadequate and they may get back less than their original investment. This is not a guaranteed product at all and should be treated with the caution that its risk/reward profile deserves.
Nigel Hewett is investment marketing director at AIG Life (UK)
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