Firm ground for income seekers

Corporate-bond PEPs can deliver high tax-free interest, but usually at some risk to your money, writes Clare Arthur

Investors who want to maximise the income earned on their money might consider using a tax-free personal equity plan (PEP) to invest in corporate bonds.

The Government extended the PEP rules last July to allow investors to shelter from tax up to pounds 6,000 a year in corporate bonds. The move was primarily designed to help UK companies raise long-term loans on the bond market, it said.

Corporate bonds are loans from investors to companies. Like gilts issued by the UK government, corporate bonds normally offer a fixed amount of interest every year and a fixed repayment price at a future date. As companies present a greater risk of reneging on their debts than the government, corporate bonds have to pay a slightly higher rate of interest to attract investors.

Newly issued bonds range in term from five years to anything up to 30 years but, to be eligible for PEPs, bonds must have at least five years to run. PEPs can hold bonds issued in the UK or on the international Eurobond market, but both types must be issued by UK companies. In addition, bonds issued by banks and building societies are excluded. Preference shares and convertibles, which also pay a fixed dividend, may also be included in PEPs.

Two "yields" (rates of investment return) tend to be quoted for bonds and other fixed-interest securities: the running yield, which is the income divided by the current market price of the bond; and the redemption yield, which also takes into account any capital gain or loss to repayment. Both figures are quoted for the corporate-bond funds that make up PEPs. The first yield figure is important for knowing what level of income or interest you can expect, while the second should help to warn you if that high income means your capital might be eroded.

Although fund management companies were quick to revamp existing funds or launch new ones to meet the new PEP rules, investors were initially slow to commit their money. But according to the Association of Unit Trust and Investment Funds, interest in this new type of PEP has shot up over the past few months, and more than pounds 900m has been invested.

While the rates of income yielded by corporate-bond PEPs are high, ranging from about 7 per cent to 9 per cent (the running yield), such investments offer very little chance of capital growth. Some funds, including those that deduct annual management charges from the capital rather than income, may erode the value of your capital (the money you originally put in). Investors should bear in mind that the funds with the highest yields are likely to expose investors' money to the greatest risk of capital loss.

The value of bonds can be very sensitive to interest-rate movements. As interest rates rise, the fixed level of interest paid by bonds becomes less attractive and bond prices may fall.

People who believe interest rates are likely to rise in the near future may prefer to steer clear of corporate-bond PEPs for the time being.

Amanda Davidson, a partner with London-based independent financial adviser Holden Meehan, says: "Corporate-bond PEPs don't suit everyone - those who want capital growth as well as income, who are worried about interest rates or are simply adventurous investors. They would all be better off sticking to equity-based income funds.

"But we are happy to recommend them to those investors who are looking for high income and who don't want a huge amount of risk."

Davidson recommends the M&G Corporate Bond Pep, which has a running yield of 7.8 per cent and a redemption yield of 7.7 per cent. The fund has no initial charge but levies an exit charge ranging from 4.5 per cent in the first year to 1 per cent in the fifth year. The fund also has an annual management charge of 1.25 per cent.

She also likes corporate-bond PEPs run by Standard Life and Norwich Union, because both insurers have long experience in managing fixed-interest securities. The NU Sterling Bond Trust, which has an initial charge of 3.95 per cent and annual charge of 0.8 per cent, has a running yield of 7.72 per cent and and redemption yield of 7.39 per cent. Standard Life's Premier Income Trust has a running yield of 7.99 per cent and a redemption yield of 7.48 per cent. The initial charge is 3.25 per cent while the annual charge is 0.95 per cent.

Graham Hooper of Chase de Vere Investments in Bath likes Commercial Union's Monthly Income Plus Pep, which yields 8.75 per cent a year (8.12 per cent redemption yield), paid in monthly instalments. He says: "It's one of the few corporate-bond funds with a track record of seven years. This shows that the fund would have protected investors' capital as well as yielding income."

Commercial Union levies an initial charge of 4 per cent and annual charge of 1.5 per cent.

For nervous investors, Hooper recommends the Sun Alliance Corporate Bond PEP, which for an extra charge guarantees to return investors' capital on the sixth anniversary. This PEP offers a running and redemption yield of 7.04 per cent, paid quarterly. There is no initial charge and the annual management charge is 1 per cent.

One sure way to know exactly what level of income and maturity value you will receive is to invest in just one or two bonds and hold them until they mature.

A corporate-bond PEP run by Bristol independent financial adviser Hargreaves Lansdown does just that. The IFA allows investors to put their money into one or two bonds out of a choice of four.

The four on offer are a Tesco bond maturing in 2003 with a running yield of 8.5 per cent and redemption yield of 8 per cent; Glaxo (2005) with a running yield of 8.66 per cent and redemption yield of 8.4 per cent; Commercial Union (2005) with a running yield of 8.65 per cent and redemption yield of 8.5 per cent; and Eastern Electricity (2025) with a running yield of 9.42 per cent and redemption yield of 9.28 per cent.