Bond PEPs prepare for lift-off

Nic Cicutti reports on new funds that seek to raise pounds 6bn after the resolution of a tax niggle

PREPARE for a bombardment. In the next few weeks, investors will be assailed from every quarter by fund managers promoting their particular brand of corporate bond personal equity portfolio.

Investment companies are hoping to attract at least pounds 6bn into their new products in the next few years. Some launches had been threatened by a tax row between fund managers and the Inland Revenue.

The Revenue recently announced a regime under which gains made on bond holdings would be taxed. At present, only distributed income is taxed while capital gains are not. This could have had the effect of lowering overall income paid to investors from the PEP. But talks between both sides mean that corporate bond PEPs will now be exempt from the new tax rules.

Even so, care is needed when making a choice - both when deciding whether corporate bonds are the right vehicle and in picking the right one.

Bonds are certificates issued by companies, the Government or local authorities, promising to pay back money they have borrowed from an investor.

This loan is repaid at a specified time, known as the redemption date. Until then, bond owners receive a fixed rate of interest, called the coupon. Most bonds have a fixed coupon, which is set at the time they are issued - they are therefore known as fixed-interest securities.

Interest paid, either six-monthly or annually, on the money is generally higher than the yield on shares.

The biggest issuer of bonds is the Government, whose gilts are often seen as a particularly safe investment, because the prospect of a default would fundamentally affect the market's willingness to lend any more money to a government. However, gilts will not be among the bonds included in the new PEPs. Building society bonds are also ineligible, unless at least 50 per cent of a PEP portfolio is invested in other bonds, which do qualify under Revenue rules.

Even so, corporate bond PEPs are generally considered a safer investment than equity funds, because the companies' bonds will undergo tight risk assessment by fund managers considering them for their portfolios.

There is still a risk involved in corporate bonds. This takes two forms - market risk and default risk. Market risk relates to changes in interest rates. If they rise, the pre-agreed rate paid to investors will look less attractive so the price of the bond falls. Conversely, if interest rates fall, the bond's value goes up, because the coupon seems more attractive to other potential investors.

Default or credit risk is where a company issuing the bond goes into liquidation and defaults on the loan. Proper risk assessment can minimise this, but as investors in pounds 100m of Barings bonds found earlier this year, the unthinkable can happen.

Pooling money with other investors in a wide range of bonds is one way of minimising this risk.

The types of bonds likely to be chosen for investment purposes take several forms. Deciding on how much risk one is willing to accept means finding out what proportion of each kind of bond is held in the PEP.

Preference shares are also eligible for corporate bond PEPs. These are company shares that pay fixed dividends. If a company does go belly-up, preference shareholders have a priority over ordinary shareholders when assets are sold. Because they are part of a company's share capital, they have a slightly higher risk profile than normal bonds. On the other hand, their yield is higher.

Convertibles offer a fixed yield and give the option, on certain dates, of converting at prearranged prices into the ordinary shares of a company.

The potential to participate in underlying stock movements makes them a half-way house between ordinary shares and bonds.

Corporate bonds have a fixed life and are redeemable by a company at their face value. They offer a higher yield than convertibles. Debentures are the most secure - they have first call on a company's specified assets if it goes into receivership.

One factor to note is that the higher the yield, or income, from a corporate bond, the higher the risk of capital losses.

Investing directly in bonds and avoiding fund management charges is possible. Using a stockbroker to buy bonds and then holding them in a self-administered PEP is an option for sophisticated investors. But dealing charges are likely to restrict investments in more than a handful of bonds, whereas pooling resources spreads risk and increases opportunities.

That said, who are corporate bond PEPs suitable for? The most likely investors are older people needing a higher tax-free income - most likely to be in excess of 8 per cent a year- than is now available through building society deposit accounts or tax-exempt special savings accounts (TESSAs).

Their attraction is even greater for higher-rate taxpayers. A further plus will be that management charges are likely to be significantly lower than the 1.25 to 1.5 per cent annual fee usually levied by PEP funds.

But they are not suitable for investors seeking capital growth - equities have repeatedly tended to outperform bonds over the longer term, even though their yield is lower.

One point to watch is how charges are levied. Some funds will boost their yield by charging management fees against the underlying capital rather than income. This means that there is a bigger income payout but also a risk of significant long-term capital erosion of the investment itself.

Finally, given the vast range of corporate bond PEPs being launched in weeks to come, it pays to obtain independent advice as to the most suitable. IFA Promotion will supply lists of the nearest advisers to callers on 0117 971 1177.

Companies are likely to offer a variety of literature explaining their products. It pays to read the brochures carefully before reaching any decision.

How the new bonds measure up

Gross Fixed/variable Net Rtn after interest income (25%) tax (40%)

Corp bond unit trust PEP 7.0-8.5% Variable 7.0-8.5% 7.0-8.5%

Income share PEP 3-6%* Variable 3-6%* 3-6%*

Building society deposit 8.0% Fixed 6.0% 4.8%

Insurance co guaranteed 6.9% Fixed 6.9% 5.9%

income bond

Nat Savings income bond 6.5% Variable 4.9% 3.9%

Insurance co distribution 5%** Variable 5%** 5%**

bond

*This income should rise in most years but could fall.

**Some higher-rate tax could be paid (up to 15% of profits) when a bond is cashed in, or on income withdrawals over 5% of original investment.

Source: Aaron Partnership (01908 281544).