INCOME VERSUS GROWTH: Extra, extra, read all about it

Don't just look at the headline rates for corporate bond PEPs, writes David Burrows

Counting the number of shopping days to the PEP deadline is reminiscent of a Christmas rush. And with many PEP providers open for business through the Easter weekend up to the 5 April deadline, buying is likely to continue to the wire.

Many of these investors are piling into corporate bond PEPs. The headline income of around 5 to 8 per cent, tax-free, is better than you can get from savings accounts. All returns can be re-invested, so you don't have to be an income-seeker to benefit.

There is debate about how much risk you are taking on when you buy a bond fund with an income of 7 per cent or more. M&G launched the first higher-yield bond when it set up the High Yield Bond Fund last September. The fund is paying out 7.3 per cent. Schroders, Framlington and Perpetual offer similar products.

As Chris McGinty, head of fixed income at Murray Johnstone, explains: "It is essential for investors and their advisers to differentiate between funds. High-yield funds should only be used within diversified portfolios, and investors considering corporate bond funds should look at the risk profile of some of the funds being advertised. The real concern is investors looking for income who `buy off the page', direct from advertisements. They are more likely to buy a high headline rate without understanding the risks."

High-yield fund managers don't just buy bonds for their income but also try to pick ones which have the prospect of an upgrade in their investment rating. The company bonds should then benefit from a capital gain. The reverse can also happen, which is the gamble built into a high-yield bond.

You'll save at least pounds 180 on a pounds 6,000 PEP by using a discount broker which refunds commission. Most offer literature, not advice, to help you make a decision. You can see an independent financial adviser, but he or she will take commission if you buy a recommended fund.

When you search for the right bond fund, look at what sort of investments are held. Only half of a bond fund needs to be invested in UK fixed-interest securities for it to qualify as a PEP; the rest could be in anything, including riskier preference shares. This could make the income rate look enticing but you may not want the increased capital risk. Tessa Murray of M&G warns: "Beware of the yields quoted in company literature which can mask a multitude of sins. Make sure the quoted yield includes charges and the provider gives you both the distribution yield [what it is paying out at the moment] and the redemption yield [the total return you will get from the bond, assuming you hold it until its maturity date]. This is the most straightforward way to judge a portfolio's quality."

Theodora Zemek, head of fixed income at M&G, stresses that you should take redemption yields into account. "These bonds must be looked at on a yield-to-maturity [redemption], total-return basis, rather than as a simple coupon [the fixed-interest payment paid on the bond] divided by price."

However, if you take this approach, it may look as though you're going to lose money. That's because your fund will lose capital if the fund managers hold the bond until its redemption date. During its life span a bond can trade for more than its redemption value (normally pounds 100), but if you hold it until its expiry date you only get the redemption value back.

This can upset investors, but M&G suggests this will happen with any bond - including government bonds (gilts). In practice, a manager may well sell up while prices are high and swap the money for bonds which are better value. Deciding when to sell is one of the skills needed to run a bond fund.

Low inflation and low interest rates greatly improve the outlook for bonds. They will also continue to benefit from a 20 per cent tax credit after 6 April, unlike dividends from equities which will receive just 10 per cent.

The launch of the euro and the UK's expected entry into the single currency are also good developments for bond funds. As a result, many European companies have started to issue corporate bonds and the bond market is likely to boom over the next few years.

M&G has produced a free guide to understanding corporate bonds. Ring 0800 210 200.

Discount PEP brokers: Allenbridge, 0800 339999; Chelsea Financial Services, 0171-351 6022; Elson, 0800 0961111; The PEP Shop, 0115-982 5105. IFA Promotion: will supply you with details of local independent financial advisers. Call 0117 971 1177.

THE TOP FIVE CORPORATE BONDS

Lump sum of pounds 100 invested in May 1994; % change at February 1999; and what that pounds 100 is worth now.

1 M&G Corporate Bond; 87.38%; pounds 187.38

2 CGU PPT Monthly Income Plus; 63.46%; pounds 163.46

3 Guinness Flight Sterling Bond; 47.13%; pounds 147.13

4 Save & Prosper High Income; 45.95%; pounds 145.95

5 Govett Corporate Bond; 40.67% ; pounds 140.67

Source: Micropal 24/2/99

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