Squeeze out every last drop

High income bonds - sold by many high street banks and life companies - aim to pay around 10% a year in an environment, when squeezing half that rate is increasingly difficult.

To produce this income quart from a pint pot, investors enter into a contract that promises them a regular payment - typically for three to five years.

But banks and insurers cannot produce this extra return out of thin air. They have to balance the high income with complicated arrangements where some or all of the original capital could be lost on the plan's maturity.

The sellers of high income bonds go to banks such as UBS or Barclays Capital which specialise in investments based on derivatives - futures and options. These set up rocket science style packages that effectively match the cash from private investors to the needs of large institutions which want to put a floor on potential investment losses.

These big investors are prepared to give up some potential equity market gains in return for compensation if share prices turn sour. So whether bond investors receive their initial investment back in full depends on the behaviour of one or more stock market indices such as the FTSE100, the American Standard & Poors 500 or the Eurostoxx 50.

The original bonds were based on the Footsie alone. More recent offerings have had to depend on more than one index, increasing the risk to income investors, because it has become more difficult to hit the magic 10% needed to make marketing attractive. Most of these bonds are either sold by banks directly to customers or by mailshot IFAs. Virtually all purchasers are retired or approaching retirement.

If one or more of the stated indices fails to reach a stated target - the original level, or never falling more than 20% below, or doing so and then fully recovering - investors lose a proportion of their capital, usually based on how far short the index or indices fall from the target. So far, only a handful of bonds have resulted in capital losses.

At the end of the policy period, money flows either from the investors buying protection to the bank or insurance bond in one capital sum - insurers make their own arrangements to pay regular income - or vice versa. But few of these bonds are guaranteed by issuers even if they meet their investment targets.

There are other small print hazards which most investors ignore or believe are so remote as to be virtually impossible. There is "bank" risk; if the bank backing the bond goes out of business the whole deal could founder.

"Counterparty" risk could hit bond values. This occurs when one or more of the parties on the other side of the derivatives fails to pay up and would result in the bank being unable to pay income investors.

And there is "tax risk"where the Inland Revenue either changes the rules or the rates. In this case, the Revenue decided, retrospectively, to move from capital gains tax to income tax.

More recent bond issues are not affected by the Revenue's ruling. Most are now based on special Dublin or Jersey based offshore investment companies.

These qualify for Isa inclusion. But investors who pay tax do so on the basis of the foreign dividend rules.

To change these, the Inland Revenue would also have to alter the way dividends from mainstream overseas companies such as General Motors or Nestlé are treated. And that would be far more difficult than changing the rules for the esoteric area of high income bonds.