Hold fire on corporate bond PEPs

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The Independent Online
OK PEP pickers. You have been bombarded with corporate bond PEP ads. You can be forgiven for feeling confused as to what you do now, faced with an already vast array of products.

The consensus among independent financial advisers that the Independent on Sunday has contacted is to sit on your hands, do absolutely nothing, and wait to see what else comes up. The Association of Unit Trusts and Investment Funds (Autif), the industry body, records 23 corporate bond PEP launches so far.

Some are new funds set up for the purpose; others are revamp- ed income funds in a PEP wrapper. As many again are expected to set out their wares between now and the end of the year. With so many new launches still to come, competition is set to hot up, and charges will most likely fall. (If you have recently bought in haste and repent your decision, remember the 10-day cooling-off period allowed under the Financial Services Act.)

Corporate bond PEPs offer high income in exchange for moderate risk and the possibility of some capital gain or loss. As a general rule the higher the income, the greater the risk, and the less the prospects of a capital gain and vice-versa. There is a risk of losses - either from the companies that issue individual bonds included in a PEP portfolio defaulting, or from high-yielding bonds being bought above their eventual repayment value. They will gradually fall back in value as they approach maturity, and if there is a sustained rise in interest rates, which will reduce the value of all fixed-interest bonds.

But the typical dividend yields of 7-9 per cent they are offering are not achievable short-term in a balanced share portfolio, and lower-risk building society rates are just 4-5 per cent.

The most cautious investor will look for products with characteristics nearest to building society products - the safest is currently the Legal & General Single Bond PEP, which guarantees an annual income of 7 per cent over five-and-a-half years, or an eventual value of 145 per cent of the purchase price if the income is reinvested. This fund attracts no charges.

At the other end of the scale, people prepared to take a hit on capital in return for high income may look at the more chancy Abtrust Fixed Interest Fund, with a projected gross redemption yield of at least 9 per cent, and charges taken from capital.

In the middle are products such as Guinness Flight's Corporate Bond Trust, whose 7.4 per cent running yield is almost bang in line with the redemption yield (which also includes likely gains or losses between now and when the bonds mature). This implies a relatively low risk profile.

Individuals requiring long-term growth, but lower risk exposure than shares, may prefer convertible share funds, such as Framlington's, with a current yield of only 5.7 per cent, but with prospects for gains in both income and capital growth.

Graham Hooper, investment director of Chase de Vere, likes the performance to date of the high yield (9 per cent) Commercial Union Monthly Income Plus fund. This fund has not changed in structure since it gained its PEP status. He also likes this product for its diversification (and hence its spread of risk) across preference shares and convertibles as well as corporate bonds.

Mike Usher, at investment advisers Brooks Macdonald Gayer, and Anthony Yadgaroff, at Allenbridge, both tip Barclays Unicorn Gilt and Fixed Interest Trust for its strong performance over time, with a relatively high yield, good diversification and low charges.

According to Autif redemption, yields are the best way of comparing total returns. Then you have to consider management charges. With most PEPs, charges are deducted from income rather than capital. Otherwise, with limited scope for capital gain, the capital could actually shrink if it has to bear the charges. The next consideration is risk, either from defaults or exposure to interest-rate changes.

Chris Moore, actuary and director of Merchant Investors, says that pressure for high yields, combined with demand created by lack of high-quality corporate bonds, may push fund managers into selecting riskier investments, with low credit ratings, in the future. This insatiable hunger for yield is what led to the junk bond disasters in the US in the 1980s, where underlying investments totally collapsed.

In the light of this pressure, the punter understandably looks for some sort of industry guideline as to credit rating. Yet Guinness Flight's move this week to get an independent assessment from credit reference agency IBCA has been greeted with dismay by voices in the industry, who say it is a too simplistic approach.

A NatWest spokesman says the AA rating achieved by Guiness Flight is not the whole picture, and that in general terms, volatility provoked by interest- rate change represents a far greater risk. "It is unlikely that A or AA rated companies will go insolvent, but it's virtually certain that interest rates will change,'' he says.

Longer bonds are more susceptible to interest-rate risk. For every 1 per cent rise on a 10-year bond, there is a 7 per cent loss in capital value. Five-year bonds only experience a 3 per cent drop. Conversely, if interest rates fall, the long bonds experience better gains.

Comparative tables outlining the features of the corporate bond PEPs on offer to date are available from Allenbridge PEP Talk and advisers Chase de Vere. Autif has a free booklet with general guidance about corporate bond PEPs. For a broader assessment of both credit and volatility risks associated with the different products on the market, investors may have to wait until September, when Allenbridge publishes its Corporate Bond PEP Calculator.

o Allenbridge PEP Talk 0171-409 1111; Chase de Vere 0800 526092; Free Autif corporate bond PEP fact sheet available on 0181-207 1361.