Bonds designed to leave savers bemused

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The theory that the right answer to the gap in information and knowledge between the investment bank’s structured products division and the person in the street is to give the person in the street more information is absurd.

I have been studying the prospectus for a “kickout bond”. Many retail investors in Britain may recently have received solicitations for these products, probably with rather more appealing names.

The typical structure of a kickout bond is something like this. If the FTSE index is higher in a year’s time than it is today, you receive a 10 per cent return and your money back (no doubt with an invitation to apply for a new kickout bond). If the FTSE has fallen, the bond runs for another year. If the index has then risen above its initial level, you receive your money back with a 20 per cent return. Otherwise the bond runs for another year. And so on. The race ends – sorry, the investment matures – after five years. If the FTSE index, having been below its initial level at the end of years one, two, three and four, now lies above it, then bingo! you get a 50 per cent bonus.

There is, of course, a catch. If you miss out on the five-year jackpot the manager will review whether or not the FTSE index ever closed at more than 50 per cent below its starting level. If it hasn’t, then you will get back your initial stake, without bonus or interest. If the index breached that 50 per cent barrier your capital will be scaled down, perhaps substantially.

Even readers of the Financial Times may need to review those paragraphs several times before understanding them. But do not bother. The most probable outcome is that the bonds yield a high fixed return, though for an unpredictable length of time. They carry a small risk of no return at all and a smaller risk of significant loss of capital. The problem of modelling the risk is far beyond the capacity not only of the average investor, but of the vast majority of the financial advisers who sell them.

The only people likely – or perhaps able – to have made a careful evaluation of the properties of this type of bond are employed in the structured products division of major investment banks. Such banks will have constructed the customised option that makes the product possible. We can know only that the answer their calculations give is unfavourable to the purchaser, because the difference between the price of the option to the purchaser and its underlying value pays for substantial set-up fees, commissions and marketing costs.

No one could responsibly be advised to take out such an investment. Like so many structured products, these bonds are bought only by people who do not really understand what they are doing. The typical purchaser is greedy enough to be attracted by a high headline of return – in this case, 10 per cent a year – and credulous enough to believe that he or she is not really taking on a significant level of risk in order to achieve it.

In a world of complex products and equally complex production processes, consumers are protected from unsafe cars and toxic foods by a combination of regulatory action and supplier concern for reputation. Public agencies prohibit the sale of dangerous cars and food, and companies such as Ford Motor, Nestlé and Tesco do not want to sell them. But neither reputation nor regulation seems to achieve these results for retail financial services.

The manufacturers and distributors of these products care more for short-term profit than building relationships with their customers. Sadly, the kickout bond I have been looking at is issued by the 86 per cent publicly owned Royal Bank of Scotland, and distributed by Barclays Wealth.

The regulatory agency, the Financial Services Authority, is in the grip of a theory that the right answer to the gap in information and knowledge between the investment bank’s structured products division and the person in the street is to give the person in the street more information. But the idea that small savers are equipped to assess the risk associated with these products by reading the small print is absurd; as absurd as the notion that consumers can protect their families through DIY toxicology assessments of the food they buy or that they can judge car safety by reading the technical specifications.

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