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Why Guaranteed Equity Bonds Are Suspect

(But great business for the banks that sell them)

It's an investor's utopia to be able to invest 'risk free' with no chance of losing money, only potential profits.

And this is what Guaranteed Equity Bonds (GEB) claim to do.

But as ever when the banks are involved it's worth looking beyond the glossy marketing to see what you're really buying.

What is a Guaranteed Equity Bond

For starters a GEB is not guaranteed nor is it a bond. The name I believe was made up by the marketing departments of the banks to sell more of the product, ie give them a nice, friendly and above all secure name.

  • Most GEBs are for a term of 3-5 years and theoretically the original sum invested (usually a minimum of £2,000) is guaranteed (more on this below)

  • The GEB will be linked to how a stockmarket performs, say the FTSE 100

  • For example, it will pay out 125% of the FTSE 100's gain over the 5-year period

  • Therefore if the stockmarket rises by 50% over the 5 years the GEB will return £3,250 (remember the bond pays out 125% of any gain (62.5% is 125% of the 50% gain in the stockmarket)

  • If the market falls by say 30% over the 5-year period you'll get back your £2,000

So on paper a GEB looks like a great deal. No chance of losing your original sum if the market tanks and it pays out more (125% in the above example) than the market rises.

But to properly work out whether a financial product is a good one, you must always try to balance its advantages with its disadvantages. Of course, most won't be told any negatives by those with an interest in selling GEBs.

Disadvantages of GEBs
  • Dividend income - This is the biggest downside to GEBs and one which most buyers won't realise, and of course won't be told about. GEBs don't receive a dividend income from the shares or indexes they invest in. Shares usually yield between 2%-4% a year via dividends and when that's compounded over 3-5 years it adds up

  • Inflation - If the stockmarket moves lower over the term of the GEB you should get your money back (assuming the firm that managed the GEB is still in business - see below) but its value will have been eroded by inflation. For example, £5,000 in today's money won't have the same purchasing power in 5 years time

  • Inflexible - Your money is locked up for the term with no chance of early redemption and for many people 5 years is too long. As a good rule of thumb you want your financial products to be as flexible as possible - For more on why this is important see secret number 3 - Buy simple and flexible - which is one of our 10 Secrets to Good Personal Finance

  • Tax - All returns from GEBs are taxed as income and not capital gains (CGT). For many this will be a disadvantage as it could push their earnings into a higher tax band

  • Charges - Charges are where most financial institutions make the big money. And the beauty about selling GEBs is that the charges and costs can be skilfully hidden within the product. So much so it's often impossible to work out exactly how much they cost. Some independent financial advisers estimate charges to be between 8% - 12% which is an incredible amount. Plus, GEBs pay juicy commissions to the IFAs that recommend them - bear this in mind if your financial advisor suggests you invest in one........

  • Very complex - GEBs might seem simple when the simple facts are presented via a glossy brochure. However, try to properly understand the small print and it's all but impossible. And a common sense rule with personal finance is never buy a product you don't properly understand as this means the seller will normally always have the upper hand. For more on why this is important see secret number 3 - Buy simple and flexible - which is one of our 10 Secrets to Good Personal Finance
Who says GEBs are actually guaranteed

The banks will tell you that any money invested into a GEB is 'guaranteed' but chances are they're being less than truthful.

Sadly, the 'G' in GEB is a play on the word 'guarantee'. Most buyers will think the guarantee means their money is safe whatever happens to the markets. And that's somewhat true, if the stockmarket was to fall 50% or even more the initial sum invested is guaranteed.

However, who offers the guarantee and what happens if they go bust?

GEBs are guaranteed by the company that develops and markets them and both Lehman's and a smaller firm called TrackData were heavily involved in GEBs - and both companies went bust.

So investors in their GEBs were horrified to learn the word 'guarantee' was more about marketing than it offered any real substance. The investors are now having to line up and see if they'll get any compensation (note - recent press has suggested that most if not all retail investors will but they've had to wait a long time).

Important note
  • Just because a GEB is sold by a big name, perhaps the Post Office or NS&I (National Savings & Investments), that doesn't mean they'll either run it or offer the guarantee
  • Chances are an investment bank develops and manages the GEB while the institution brands and sells it
  • In such a case the 'guarantee' would probably be with the investment bank
Watch out for the sneaky offshore guarantee

Another trick the sellers of GEBs have been known to use is the offshore subsidiary guarantee. For example -

  • The XYZ bank sells a load of GEBs and makes a big song and dance about the guarantee
  • However, buried deep within the small print will be a clause stating the guarantee is offered by an offshore subsidiary, perhaps somewhere like the Isle of Man
  • And offshore tax havens will have different and usually a sub-standard compensation scheme when compared to the UK version, as many investors have recently found out
So why do the banks operate in this fashion? I don't know the real reasons but I'd suspect it's all to do with maximising their profits and minimising their risks, at the expense of their customers of course.
Many financial advisers shun GEBs

It is interesting to note that many IFAs (Independent Financial Advisers) refuse to recommend GEBs to their clients. For two main reasons -

  1. Whereas GEBs seem simple to understand, the small print is notoriously difficult to comprehend. And if a professional adviser can't make head or tail of it, then how can he justify selling it to clients

  2. No two GEBs are the same. For example, they are all tied to different stockmarket indices (some the FTSE All Share, others the FTSE 100 etc), have different timescales, have different payouts and a myriad of other points. It's therefore hard, if not impossible to compare like with like
GEB Summary

The warning signs flash all over GEBs -

  1. Designed by the investment banks who are skillful experts at making sure they get the better deal at the expense of their clients

  2. Very opaque - related to the above, and if seasoned financial advisers often avoid them because they can't understand the small print, and therefore spot the catches, what chance does the average person stand

  3. Heavily marketed - history has proved time and time again with the financial services industry that anything they heavily promote will always better for their profits rather than the customers

For these and many other reasons contained in this article Guaranteed Equity Bonds are an extremely suspect investment for potential stockmarket investors. And to be truthful - if you're not willing to accept potential losses via investing in the stockmarket in return for potentially far higher returns, the stockmarket is not for you.

PS. GEBs are an excellent example of why secret number 3 is so important - Buy simple and flexible - which is one of our 10 Secrets to Good Personal Finance

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