A tax-free income and a touch of risk

A HANDFUL of high-income trusts have been around for years, investing in government stocks (gilts) and fixed-interest securities issued by commercial companies to attract investors who want high income and low risk rather than the possibility of capital gains.

But fixed-interest investments are very vulnerable to inflation and taxation, and UK investors have tended to prefer unit trusts and investment trusts that invest in shares, especially since the introduction of personal equity plans made it possible to invest tax-free.

The ability also to invest in high-income funds free of income and capital gains tax will transform the attractions of high income funds. Some providers/ managers will simply add a PEP "wrapper" to their existing funds and repromote them as Corporate Bond or High Income PEPS. Others will start up special funds and choose the investments to match the new rules.

Corporate Bond PEPs must invest at least half their money in fixed-interest securities, priced in sterling, issued by companies based in the UK, paying investors a fixed rate of interest, and having at least another five years to run before they are redeemed. The definition includes preference shares, debentures and loan stocks, which are all securities issued by UK companies paying fixed rates of interest, and convertible stocks - loan stocks that can be converted later into shares.

Bond fund managers can invest the balance in gilts (fixed-interest securities issued by the British Government) and even hold a proportion of cash. In practice, the bulk will be in corporate bonds because they give a better yield, but the rules allow a fair amount of variety, enough to make it necessary to subdivide the market to get a better understanding of what risks and returns are involved.

Corporate bonds are a classy American-style name for what the British call loan stocks - securities that pay the holders interest rather than earning dividends. Loan stocks have not, however, been the favourite way of raising capital for UK companies, partly because they cost companies much more than raising the equivalent amount of money through a share issue, partly because they are more of a burden on the balance sheet and are less flexible than borrowing money from a bank.

There is a parallel market in so-called Eurosterling bonds, which are loan stocks expressed in sterling and raised outside the UK. Only Eurosterling bonds issued by UK companies are eligible for bond funds, and UK investors can only buy Eurosterling bonds direct if they are registered investors and can trade in units of pounds 100,000.

However, this is no obstacle to PEP providers, which can buy the bonds in bulk and distribute them between thousands of individual Corporate Bond PEPs.

Providers can also invest in preference shares - which unlike ordinary shares pay fixed dividends but stand at the head of the queue if the company gets into financial difficulties - debentures, which are similar to loan stocks, and in convertible loan stocks. Convertibles are in effect loan stocks that can be converted into shares at a set price on or after set future dates.

By extending the definitions, the Government has put together a pool of about pounds 30bn worth of stocks that can be held in a Corporate Bond PEP.

It also hopes that by creating investor demand for bonds, it will reduce yields and encourage many more small to medium-sized British companies to use the bond market as an alternative source of capital.

In the meantime, there is no real shortage of eligible investments.

Gilts do not qualify as eligible investments, but bond fund managers only need to hold over 50 per cent of their investments in eligible investments. The balance can be invested in gilts, which generate between 1 and 3 per cent less return each year than corporate bonds but do not carry the same risks.