PEP Survey: How to yield an income

THE chief merit of PEPs is that any income your plan generates is free of all income tax. You therefore earn more than you might obtain from high street bank and building society deposit accounts, albeit with some risk.

If you have a self-select PEP, you can go for companies that pay out high dividends. But watch out. High yield is by definition high risk.

If like most investors you opt for a general PEP and have your money managed professionally, you can look at high-yielding unit and investment trusts. But these days, most do not offer that high a yield. M&G Extra Income, one of the more popular high income unit trusts, currently yields under 4.5 per cent. This means that for every pounds 100 invested, you can expect less than pounds 4.50 in income.

But don't despair. Since July 1995, corporate bond PEPs have been available. There are now some 60 different ones on offer and most of them currently yield around 7 per cent or more.

Corporate bond PEPs, not to be confused with corporate PEPS which invest in a company's ordinary shares, are often seen as safer investments than conventional plans.

They are lower risk because they invest in fixed-interest bonds and other securities issued by companies. But at the end of the day, the stock is only as good as the company that issues it. You would be right if you expected the yield on Marks & Spencer or BP to be lower than that of a small engineering company. The risk with a corporate bond portfolio is dependent on the mix of different types of stock. The yield the PEP offers depends on the fund manager's strategy.

What they will all have in common is that they are set up to generate income. In effect they are fixed-interest bonds issued by companies to raise money. Investors are therefore lending a company money for a fixed time and receiving interest on the loan.

Convertibles are similar vehicles in that, like corporate bonds, they offer a fixed rate of interest, but also offer investors the chance to convert their option into shares. For that reason they offer lower returns than corporate bonds, but do have the extra potential of enjoying the capital growth associated with equities. Convertibles have therefore often been promoted as a relatively low-risk entry into the equity market.

When comparing yields it's worth bearing in mind two things, the risks and the charges. There are often two yields quoted on corporate bond PEPs, the "running yield" and the "gross redemption yield".

The first relates to the current estimated level of income you'll get, but this can be misleading because it takes no account of any capital gains or losses.

The notion of capital rising or falling in this type of investment may seem confusing, but that's because while there may be fixed interest on offer, there is no guarantee on the capital. Bond prices go up and down according to the prevailing market conditions. The timing of buying and selling can affect the return. So don't be fooled by advertisements of "guaranteed" income or yield, which hide the fact that your capital may be at risk.

Gross redemption yield in fact gives a better indication of the return on your investment in a corporate bond PEP as it takes into account gains or losses on capital, as well as income.

How should you choose a corporate bond PEP? Obviously the yield is important but you should also take into account charges. High charges will erode your capital quite quickly whereas in an equity-linked PEP, the growth should offset this.

Some managers still make an initial charge of up to 5 per cent.

The annual charge is important as you will have to pay it each year. This ranges between 0.5 and 1.25 per cent, with most being under 1 per cent.

But watch out. Some managers boost the income generated by their fund at the expense of investors' capital. They can do this by taking their management charges out of capital rather than out of income generated.

As corporate bonds will only give modest capital gains, if any, when compared with ordinary shares, this way of taking out annual charges can erode capital.