Corporate bonds revel in a rosier future

Though suffering a poor recent record, tax benefits and the prospect of falling interest rates make corporate bonds a better proposition

All ISA investment funds offer tax advantages, but corporate bonds offer slightly more than most. Their performance may have been pretty dismal of late, but many experts argue events are slowly moving in their favour, and now may be a good time to buy.

All ISA investment funds offer tax advantages, but corporate bonds offer slightly more than most. Their performance may have been pretty dismal of late, but many experts argue events are slowly moving in their favour, and now may be a good time to buy.

Corporate bonds are loans issued by companies to raise money for their expansion. They pay a fixed rate of interest on a lump sum and are traded on the stock market. They have been hugely popular recently, primarily among those approaching, or in, retirement who want to earn income on their investments greater than that paid by bank or building society accounts, but with a relatively low level of risk.

Unfortunately, many investors have underestimated the risks they were taking with their money. "Corporate bonds have had a rotten time for the last two years, falling around 10 per cent in value, which is a large drop for a fixed-interest investment. One reason they fell is that investments paying a fixed level of interest are less attractive when interest rates were increasing," says Andrew Jones, investment director at financial advisers David Aaron Partnership.

With interest rates widely expected to fall, corporate bonds should start to look more attractive, but there are no guarantees. One continuing danger is that a wider economic slowdown could hit their prospects. If the world economy struggles, growing numbers of corporate bond issuers could default on their loans.

Rather than investing in individual companies' bonds, most private investors buy a corporate bond fund, which reduces the risk that an individual company will default on its loan by investing in a series of bonds. But these funds do not escape risk altogether.

Corporate bonds can be bought as part of your annual £7,000 Individual Savings Account (ISA) allowance. They are the most tax-efficient stocks and shares ISA of all.

Such has been the hype surrounding ISAs most investors assume ISA stocks and shares funds don't incur any tax. Though all returns are free of income tax and capital gains tax, only corporate bonds escape the taxman altogether.

Pooled investment funds such as unit trusts, investment trusts and open-ended investment companies (OEICS), which form the underlying fund of most stocks and shares ISAs and are sold by big-name companies such as Aberdeen, Fidelity, Gartmore and Jupiter, still incur a tax charge within the fund.

In April 1999 tax credits on dividends from UK equities were reduced from 20 to 10 per cent, and from April 2004 this credit will disappear altogether. Its withdrawal will primarily hit stock market investment funds that use these dividends to pay investors an income. Known as equity income funds, they include popular names such as Jupiter Income and Newton Income. Capital growth funds should be unaffected. The good news for income-seekers is that corporate bond funds will continue to receive the full 20 per cent tax credit. There will be no tax deduction of any kind from your fund.

"Most equity income funds yield 2.5 per cent to 4 per cent, which means they will not be hugely damaged, but it does give corporate bonds the tax edge," Jones says. "Tax should not be the sole determining factor when selecting an investment, but if you want a high income, a corporate bond ISA is a very tax efficient way of getting it. These funds are also lower risk than equity income funds, and although corporate bonds have fallen recently, the losses were not as dramatic," he says. Jones says his preferred corporate bond funds are M & G High yield, followed by Perpetual Monthly Income and Schroders Monthly High Income. Mike Rostron, director of MGP Investment Management, says investors who hold sizeable sums in a combination of growth investment trusts and income-generating vehicles such as equity income funds and corporate bond funds, should juggle their investments carefully to minimise their tax liability.

"You pay no income tax on the returns from those unit trusts and investment trusts that have been designed to give you capital growth. You only are liable for capital gains tax, but since your annual threshold is £7,200, it is unlikely you will pay that tax anyway. It is therefore less important to hold these funds within an ISA," he says. "Instead, you should hold those income-generating funds such as corporate bonds within a PEP or ISA wrapper, as this will allow you to take all returns free of income tax."

Corporate bond funds are often advertised with headline rates of up to 9 per cent, highly tempting when base rate is just 6 per cent and likely to fall. But as with every other investment, the higher the potential return, the more risk you are taking.

The interest paid by an individual bond depends on the credit rating of the issuing company. Funds paying a high level of income are known as high yield corporate bonds. They invest in sub-investment grade bonds (junk bonds) issued by companies with lower credit ratings. These companies must pay higher interest to attract investors, because there is a greater chance they will default on the loan.

Bonds publicise two yields, a running yield and a gross redemption yield. The running yield is the current income you actually receive, the redemption yield is your overall return if you encash the bond, and is usually slightly lower. Aberdeen Fixed Interest, for example, has 8.4 per cent running yield and 7.2 per cent redemption yield (see table).

Colin Jackson, financial adviser at Baronworth Investment Services, says higher running yield means there is a danger your initial capital is being eroded. You should therefore check both yields.

Management charges may also hit your return. Check whether the annual management fee, typically set at between 1 and 1.5 per cent, is deducted from the bond yield, or from your capital.

"Where corporate bond funds deduct charges from your initial capital, the headline yield will look more competitive than it actually is," he says.

Among funds listed in the table, Aberdeen, Credit Suisse, Edinburgh, Jupiter, Merrill Lynch, Newton, Perpetual and Schroders all deduct annual fees from your capital.

Beware also exit charges. M & G, for example, charges a 4.5 per cent exit charge in the first year on its corporate bond and high yield bond funds, falling to 1 per cent after five years and nil thereafter. "Most people should be holding bonds for a long period, so this should not be that damaging," he says.

Jackson's preferred corporate bond is M & G High Yield, which currently has a running yield of 8.28 per cent and a redemption yield of 9.4 per cent. "It has a very good running yield and its 1.25 per cent annual management fee is deducted from yield rather than capital, which makes it even better," he says.

He is optimistic about corporate bonds' prospects generally. "I believe they are going to perk up. However, you should not invest for the short term or expect guaranteed returns, because they do not exist. You must accept there is a risk to your capital," he says.

* Contacts: David Aaron Partnership 01908 281 544; MGP Investment Management 0800 783 0768; Baronworth Investment Services 020 8518 1218.