Eurosterling joins the PEP portfolio

A ruling by the Revenue has made corporate debt attractive as a small investment option. Clifford German reports
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BRITISH dentists may be about to replace Belgian dentists as the typical investors in fixed-interest bonds. This could be the result of the Inland Revenue's ruling allowing Eurosterling bonds - sterling- denominated bond issues made by British manufacturing and services companies outside the UK - to qualify as appropriate investments in corporate-bond personal equity plans.

The corporate-bond PEP market was created by the Chancellor last November. The Revenue ruling, however, in effect doubles the size of the sterling bond market eligible for PEPs from £16bn to £32bn - and enthusiasts such as brokers BZW now believe UK investors could invest up to £6bn in corporate- bond PEPS by the end of the century, by when they could account for about 20 per cent of the total PEP market.

The demand could also make it worthwhile for many smaller and medium- size British companies, which are unwilling and unable to issue more shares, to tap the market for fixed-rate capital at considerably lower cost than borrowing from a bank. Until now, the relatively small number of investors has made it difficult to trade in bonds issued by smaller companies, and the lack of available investors has made the market too illiquid.

The corporate-bond PEP is attractive to investors because it is a debt instrument, issued by specific UK companies, that offers a fixed rate of interest and value when it matures but can go up and down in value meanwhile, as interest rates fall or rise. Depending on the quality of the company that issues the bond, the yield can be anything from 0.6 per cent to 1.5 per cent above the yield on a British government stock of comparable coupon and maturity date.

These premiums have narrowed fractionally since the corporate-bond PEP idea was first announced last November, but the margin is still attractive.

With government stocks already yielding up to 8.7 per cent gross if held to redemption, the yields available on corporate bonds are substantially higher than on most shares, on the deposits in banks and building societies, or on conventional money market instruments.

Add the advantages of being able to invest £6,000 in a corporate-bond personal equity plan that is exempt from income tax on both dividends and capital gains, and the corporate- bond PEP could help UK investors to overcome their traditional reluctance to buy fixed-interest securities.

Unsecured bonds, debentures that are secured against the issuer's assets, and convertibles - which start off as fixed-interest bonds but can be converted, usually on attractive terms, into shares in due course - are all eligible for corporate-bond PEPs so long as they have a minimum life of five years. So are preference shares, which earn fixed dividends but rank ahead of ordinary shares in the event of financial trouble.

Corporate bonds are not devoid of risks. Much was made of the fact that Barings Bank debentures, which became worthless when the bank collapsed six weeks ago, could have been eligible for inclusion. But the risk is clearly visible from the name of the issuing company, and higher risks are rewarded by a suitably higher yield.

A wide range of issuers are already available, from Hanson to Tesco and McDonald's, and maturity dates extend as far as 2044, when British Gas will repay its long-dated stock. Issues maturing in 15 years or more are generally secured, but shorter maturities are often unsecured. The new demand is also expected and certainly intended to bring in a large number of new borrowers to add depth and variety to the market. Individual investors may still feel unfamiliar with corporate bond investments, but investment and unit trusts that can be held as PEPs will be able to invest up to 50 per cent of their assets in corporate bonds. This will enable managers to take the worries off the shoulders of individual investors.

If BZW is right, the corporate-bond PEPs could carve out a significant piece of the personal sector's estimated holdings of £450bn in deposits, national savings and gilt-edged stocks. They should appeal particularly to individuals with substantial existing investments who are looking for higher rates of return than building societies can offer, low risk and tax advantages. They could also appeal to holders of £25bn worth of tax- exempt special savings accounts (Tessas) when initial holdings come up for re-investment next year.