Prospects and perils of new PEPs

Christine Stopp explains why investors should go slowly and warily with the latest tax-free equity rules
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The Independent Online
A 10 per cent tax-free regular income, or a magnet for dodgy issues, which the private investor should treat with the utmostcaution?

Industry opinions on the Chancellor's decision to make a range of fixed-interest stocks PEP-eligible embrace both these extremes, and many points in between.

On the face of it, PEP managers agree, the freedom to include convertibles, preference shares and some types of corporate bond will enhance investors' portfolios, offering higher yields and less capital risk than the equity market.

Warning investors to plan now in order to gain maximum advantage from the new rules, stockbroker Killik suggests thatincome investors who have large sums on, say, three-month deposit, should give notice on their money now, with a view to investingin April.

Since the new rules will not come into force until the start of the new tax year, it is not theoretically possible to use thecurrent (1994/95) PEP allowance to invest in non-standard shares. The Killik strategy proposes that, using a self-select PEP, investors should invest the present year's £6,000 at the end of the tax year, holding it in cash until the new rules come into play. After the start of the new tax year, a further £6,000 could be invested.

In this way a married couple could have an instant £24,000 tax-free income portfolio. Killik lists a number of convertibles and preference shares that it is currently recommending. As the table shows, the convertible yields are substantially higher than those on the ordinary shares, and some of the preference share yields are above 10 per cent.

The general warning to plan now for the expansion of the PEP rules is timely, though the best advice is probably to make cash available and await further developments. PEP managers will be producing special offers and new products between now and the newtax year. Also, the new rules are still being worked out.

Jonathan Haile of NatWest stockbrokers, who chairs the PEP Managers Association Tax Committee, says there is "still a fair amount of water to go under the bridge before we know what is happening in fine detail".

The new range of eligible investments is still not clear, although the initial statement said that loans, debentures, preference shares and convertibles may be included provided they have a life of at least five years to maturity and are not in the financial sector (this is presumed at present to mean banks and building societies).

Some technicalities have yet to be cleared up. Mr Haile thinks it probable investors will be allowed to switch existing PEP money into the new classes of asset - without which the Killik strategy for using the 1994/95 allowance would not be viable.

With so much talking still to be done between the Treasury and the industry, it seems possible that the rules may not even be ready for the new tax year. This could threaten the Killik strategy: there is no limit on how much cash may be held in a PEP, but it must be on the understanding that it is to be invested. Someone holding a full year's PEP allowance in cash for more than a very brief period might attract Revenue disapproval.

This need not be a problem. The 1994/95 allowance could be held in equities and transferred at a later date into fixed interest. Groups may well be offering favourable terms in due course for this kind of switch.

Investors who prefer to hold stocks directly but are worried about choosing them will find many self-select stockbrokers now offer guidance on what to choose. But brokers whose business is explicitly "execution only" do not normally give advice.

Advice will certainly be necessary unless you have made a hobby of following the new types of stock. Convertibles and preference shares do not offer security of capital, and can sometimes act unpredictably in relation to the equity market. The late 1980ssaw a boom in poor quality preference issues offering high yields. In a number of cases the issuing company went bust. It is therefore important to assess the quality of the issuer.

Preference share prices are up by around 10 per cent already since the Budget, and anticipated demand is likely to distort prices further between now and the introduction of the new rules. There could also be a rush of new issues, perhaps not all of goodquality, from companies keen to capture PEP investment money. This suggests that one should either buy now, outside a PEP, and transfer holdings into a new 1995/96 plan, or hold off until prices have settled again.

The fund manager Prolific is offering a discount on units in its convertible and preference funds until the end of this tax year, with a free transfer thereafter into a PEP. Managers we spoke to would agree with Prolific's Mike Webb, who thinks that "headline-grabbing yields mean excessive risk". The Prolific convertible fund currently yields 6.3 per cent and the preference fund 7.1 per cent.

There is still time, but it is advisable to aim for no later than the end of March, depending on your PEP manager, to secure this year's allowance, but watch for new offers and rule changes.

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