Eurobonds come to the high street

The Inland Revenue yesterday launched its draft regulations on fixed-interest personal equity plans with all the flourish of a minor Eurobond issue. Most investors might have missed it.

But if the Revenue is not given to over-excitement - especially when announcing significant tax saving opportunities - the City marketing machine is about to go into overdrive.

By allowing investors to accumulate corporate bonds, preference shares and convertibles tax-free through PEPs, the Government hopes to give middle- ranking British companies better, and cheaper, access to the capital markets.

Research, published this week by BZW, the investment bank, suggests that the Budget initiative is likely to be a blockbuster, representing the biggest shift in investor and saver attitudes for a considerable time.

BZW forecasts that demand for corporate bond PEPS will escalate to £6bn a year by 1999. The attractions of a low-risk, high-yield, regular tax- free income will attract a wall of risk-averse money from traditional savers in a way that unit trusts and shares have failed to do.

The investment bank estimates that there is £448bn of liquid savings looking for a "strong credit product".

Because they are so suitable for topping up pensions and mortgages, corporate bond PEPs will mark a fundamental shift from investment to savings as PEPable bonds become an integral part of financial planning.

The anticipated demand for corporate bond PEPs had led the City to lobby hard for the inclusion of Eurosterling bonds, sterling issues made on the international markets by UK companies such as British Gas and BT. The Revenue yesterday announced that they would.

Without Eurosterling a potential bond market of £32bn would have been halved and the range of qualifying investments hugely diminished.

With an estimated £6bn a year chasing stock worth only £16bn there would have been a serious danger of poorly structured risk being dragged into the market to meet demand.

"We are delighted that the Government has listened to the unit trust industry and included Eurosterling bonds as PEP-qualifying,"Jack Springman, a director of Guinness Flight Asset Management, said. "It is not making the mistake of drawing the rules too tightly, as was the case when PEPs were first introduced." So who should be buying these fixed-interest securities now that they have become tax-efficient?.

The answer is those who are looking for additional income but prefer more security than ordinary share -based products can offer.

BZW claims that Bond PEPs produce at least 1 per cent more income per year for ordinary investors than other savings products.

However, bond PEPs are not a substitute for short-term bank and building society deposits. Like any other investment they do not come risk-free.

The general rule of the higher the income the higher the risk applies. But while their value may prove volatile in the short term, bonds do repay the full amount on maturity. That is what makes them so suitable for financial planning.

They are not suitable for savers who may need to draw on their capital at short notice.

Shorter dated bonds, including most Eurosterling bonds, tend to offer lower rates. For example: a Hanson 10 per cent Eurosterling bond would offer a basic rate taxpayer a return of 7.31 per cent.

In a PEP the same stock would produce a return of 8.74 per cent.

That compares with 7.5 per cent from a Tessa, 6.375 per cent from a fixed- rate building society deposit. Longer dated bonds offer higher income but more volatile prices.

Investors seeking higher income than shares can provide, but greater capital growth than from bonds, might consider PEPing a convertible.

A Carlton Communication 6.5p 2005/10 PEP would return 6.42 per cent for a basic rate tax payer. It offers the benefits of a bond but provides the prospect of share-related growth in exchange for a lower yield.

A preference share PEP will provide the highest income of the three. A Commercial Union 8.75 per cent net preference PEP, for example, would pay a basic rate taxpayer a return of 9.33 per cent.

The draft regulations, the final version of which is expected to take effect from the end of June, admit to PEPs a range of corporate bonds issued by non-financial companies. Qualifying bonds must be denominated in sterling, issued at a fixed rate and have a minimum term to redemption of five years.

Qualifying companies must not be financial companies - namely institutions authorised under the 1987 Banking Act - or their subsidiaries.

The companies must be incorporated in the UK for corporate bonds and convertible bonds and in a European Union member state in the case of preference and convertible preference shares.

The new instruments will have to satisfy certain listing requirements, unless they are held indirectly through a unit or investment trust.

Under current rules, unit and investment trusts must hold at least half their assets in UK ordinary shares and similar shares in EU companies to qualify for the full general PEP tax-free limit of £6,000.

The Revenue said yesterday that qualifying unit and investment trusts will be able to count eligible bonds, preference shares and convertibles towards the 50 per cent limit alongside existing classes of qualifying investments.

There are no changes to the rules for non-qualifying trusts (which have £1,500 limit) and single company PEPs.

5 A bond is a certificate issued by a government or a public company promising to repay borrowed money at a fixed rate of interest (the coupon), at a specified time, and to pay the orginal sum in full. Essentially, bonds are IOUs.

5 Floating rate: Some bonds have floating or variable rate coupons. But only fixed-rate bonds issued by qualifying borrowers will be eligible for personal equity plans (PEPs) under rules announced by the Inland Revenue yesterday.

5 Sterling bonds: The sterling bond market consists of a wide range of financial instruments. It includes domestic and Eurosterling bonds, convertible bonds and preference shares.

5 Preference shares: a preference share pays a dividend at a fixed rate and entitles the owner to preferential treatment on dividend payments and capital repayments in liquidations.

Some preference shares are redeemable (they have a fixed repayment date), others are not. Also, some preference shares are convertible into ordinary shares. Preference shares of "financial" companies will not be eligible for PEPs.

5 A convertible is a bond or preference share that can be converted into the ordinary shares of the issuing company at a fixed date and price. Most are convertible at the investor's option.

5 Eurosterling: Eurosterling bonds are bonds that are issued in sterling, but outside London.

They are issued by a wide range of borrowers, including companies, foreign governments, banks and building societies.

They have the same characteristics as domestic bonds and are issued outside London because the tax treatment of Eurobonds is more attractive.

One of the most attractive features of the Eurosterling market for borrowers is its capacity to raise substantial sums of money. Many Eurobonds are listed on the London Stock Exchange.

The Government yesterday said that Eurobonds from qualifying issuers will be PEPable, a move widely welcomed by the City, which had lobbied hard for their inclusion.

5 Financial company: The Inland Revenue yesterday defined financial companies for these purposes as those institutions authorised under the 1987 Banking Act. Bonds issued by financial companies were excluded from PEP eligibilty in the Budget in November. This exclusion will now also apply to their preference shares.