Skip to content
Skip to main content

About this free course

Download this course

Share this free course

Managing my investments
Managing my investments

Start this free course now. Just create an account and sign in. Enrol and complete the course for a free statement of participation or digital badge if available.

4.3.5 Precipice bonds

The image is a drawing of a climber on a rope on the side of a mountain.
Figure 11 Investments in precipice bonds came with big risks.

Sometimes investors do experience outcomes from their investments that are both adverse and unexpected. In some cases, this arises from the mis-selling of products, in others it arises due to unrealistic expectations about the prospects for an investment’s performance or, simply, lack of attention to the detail of the risks involved. You saw aspects of these issues when you looked at the performance of endowment policies in Week 2.

A further case which demonstrates issues of both mis-selling and misinterpretation of investment risks came with the ‘precipice bonds’ in the 1990s and early 2000s.

The low rates of interest that prevailed in the UK from 1993 adversely impacted on the returns from interest-linked investments. Experiencing a fall in investment income on which they may have been reliant, perhaps made it inevitable that some investors would be tempted by investments where a high income was guaranteed by the product provider.

Such high-income bonds – latterly known as precipice bonds – became prevalent in the 1990s. Between 1997 and 2004, a total of some £7.4 billion was invested by over 250,000 people in these products.

These bonds were usually offered for specified periods – typically of 3 or 5 years. The bonds either offered higher annual interest than that available on conventional products or a high growth rate in the value of the investment made. These advertised rates were guaranteed. Additionally, the bonds were marketed as being tax-efficient because the returns were not subject to capital gains tax (CGT) – in contrast to the profits made on ordinary share dealings. However, this CGT exemption would have been irrelevant for the majority of investors because the capital gains, even on optimistic forecasts, would have fallen below the profits threshold at which CGT becomes payable.

But with these high returns came high risks – the amount of the original investment made by the customer that was returned to them on the maturity of the product was not guaranteed, and was dependent instead on the performance of specific shares or indices to which the product was structurally linked. Thus, although a high income might be achieved, the customer could easily end up getting back a much reduced amount of the original capital sum they had invested.

When the equity markets fell in value sharply in the early 2000s, the risk element of these precipice bonds was triggered, with thousands of investors losing significant amounts of their capital.

A number of regulatory issues arose from precipice bonds.

Regulatory issues

First, there was the issue of mis-selling. Did the firms selling the product explain the risks in a way that could be understood by their customers? Specifically, some products were sold without the risks being explained in the prospectuses advertising them. Elsewhere, even if the risks were stated, some intermediaries did not explain them to their customers.

Second, there were issues about the process of customer classification and the risk appetite of customers. Did the firms marketing the products make credible assessments of the financial sophistication of their customers? Were there appropriate determinations of their genuine desire to invest in products which exposed them to losses on the capital they invested? Were the investments sufficiently dissimilar to the other investments held by the customers as to send out warning signals?

Third, to what extent did the designers of precipice bonds anticipate the magnitude of the fall in the equity markets in their product design? There are strong parallels here with certain of the factors that contributed to the 2007–2008 financial crisis. Risk models, used in the product design, may not have looked back far enough in history to pick up previous dramatic shifts in the market, or such falls may have been considered unlikely to reoccur. In essence, those designing precipice bonds failed in the stress-testing of the risks associated with the product.

Fourth, how quickly and visibly did the Financial Services Authority (FSA) – the regulator of financial services in the UK at the time – alert the public to the risks associated with precipice bonds?

The Financial Ombudsman Service (FOS) unsurprisingly had to respond to a large number of customer complaints about the products.

The FOS response

Although the judgements made by the FOS were, as usual, on a case-by-case basis, it made two general observations about the products.

First, even if the marketing literature for a precipice bond did make it clear that the customer might not get back all the capital they invested, this warning could be undermined at the point of sale by the firm’s agent playing down the nature of this risk.

Second, the FOS observed that few customers really seemed to understand the concept of ‘attitude to risk’ – clearly a critical concept when judging whether to invest in a risky product. This is an issue you explored in Week 3. So even if customers committed to an appetite for ‘medium’ or ‘high’ risk during the fact-finding process ahead of sale, many did not appreciate the potential consequences of this judgement.

In assessing individual cases, the FOS therefore placed great reliance on the background and investment experience of the customers who lost money in the bonds. Those considered to be experienced were deemed to have been able to identify the risks in the products and to have been capable of properly determining their attitude to risk. Such complainants tended to have their complaints rejected, whereas compensation was awarded to those ostensibly inexperienced investors who had been lured into investments they neither understood nor really had an appetite for.

Activity 4.3 Precipice bonds – mis-selling or mis-buying?

The precipice bonds case study clearly highlights both issues of mis-selling and of regulatory weaknesses. Do you think any blame should be ascribed to the individuals buying the products?

To use this interactive functionality a free OU account is required. Sign in or register.
Interactive feature not available in single page view (see it in standard view).