What Are Stock Market Linked Bonds?

These bonds are offered by insurance companies, banks, building societies and other investment firms. Stock Market linked bonds often provide the investor with a capital guarantee at the end of a fixed term and the return is linked to a stock market index (such as the FTSE or DOW). They have a variety of names such as Protected Bonds, Guaranteed Equity Bonds and Structured Products. As an investor you commit your money for say 5 years. Typically, the provider offers your capital back at the end, plus all the increase in say, the FTSE 100 index over the 5 years. These returns, however, usually have a maximum - typically around 65%. So if the index doubles, you will not benefit beyond the 65 per cent level. However, arguably in today's market, a return of over 10% per annum with capital protection is an attractive offer. The downside to this type of investment is that you can usually only invest for growth and not income. So you have to wait until the end of the term to receive your capital and interest. The provider does not actually buy shares but instead uses the money to buy a mixture of interest bearing securities and derivatives which rise in value if the FTSE 100 rises.

With the offer that you will get back at least your original lump sum these instruments provide a relatively safe way of benefiting should the stock market index rise significantly. However, bear in mind that your return is only linked to the stock market index. This is not the same as receiving the returns by holding say, the top 100 shares. First you are missing out on an important element of return, the dividend income. Second, you usually only receive a proportion of the capital gain over the 5 years, not the full gain. Furthermore, there are stock market linked bonds that don't provide complete protection on downside. Some providers offer the investor your full capital back after a stated term IF for the example the FTSE 100 does not fall to below 50% of its initial value at the start of the plan. If the market does fall below 50% then this is where the danger lies, and if it fails to recover to the initial value at the start of the term then the capital is at risk.

The other risk to these types of investment is counterparty risk. Basically the capital guarantee or rather capital protection (investment companies don't like using the word "guarantee") is only as reliable as the company that is providing the capital protection. If the company were to go into liquidation then the capital protection is at risk. In some cases, companies have been bought have got into trouble and been bought by another company and the capital protection has remained, in others it hasn't. Of course, if you like the idea of stock market linked bonds then this should only form part of your portfolio and it's important to spread your capital across a wide diversification of asset classes.

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