Investing for Income: The trendy way tomakemoney

Corporate bond PEPs are a hit, says David Burrows

SUDDENLY the sleepy world of corporate bond PEPs is fashionable. When M&G launched its high-yield bond fund last year, many people said it would be a mistake. Yet M&G now has pounds 100m in its coffers and is paying 7.8 per cent interest, tax free.

Not surprisingly M&G now has rivals. Three other firms launched similar corporate bond funds last week. Investors can now choose high-yield funds from Schroder (estimated gross yield 7 per cent), Fidelity (7.5 per cent) and Framlington (8 per cent).

If you do not want to take a slightly higher risk for a higher return, there is also a wide range of more conservative bond funds, paying income of around 6 or 7 per cent, tax free. In a world of falling interest rates and low inflation, the corporate bond fund has come into its own. A corporate bond is basically an IOU note issued by a company.

In return for a loan the company pays out interest every year until the loan expires. Some bonds have five years to run, others 30. And the rate of interest paid out depends on how secure the company is perceived to be. A riskier company has to pay higher interest on its bonds to attract investors.

So a bond fund buys a range of corporate bonds and gives its investors a regular income, tax free. That is good news but there will be extra advantages when the rules change in April and PEPs are replaced by Individual Savings Accounts (ISAs).

Income from a corporate bond PEP will get full tax relief at the individual's higher rate of income tax. Any capital gains (though they may only be quite small) will also be tax free.

After ISAs are introduced in April, you will still be able to buy a corporate bond fund and hold it as part of your ISA portfolio, so even if you cannot make the commitment, it is not your last chance. Don't believe the doom- laden advertising.

Ian Spreadbury, senior portfolio manager (bonds) at Fidelity explains: "The performance of corporate bond Peps over the last couple of years has been extremely good. Things took a little bit of a knock from the slump in the Far East. We probably won't see the same sort of yields as two years ago but it still makes sense to buy. Interest rates have just been cut further and there is little worry over the inflation rate."

As investors lock into a fixed rate of return if interest rates go up, then bonds look less attractive because a higher rate of return can be obtained in the open market. That means less demand for bonds and prices can fall. By the same token, since bonds offer investors the return of their capital at the maturity date, if inflation spirals out of control, investors' capital sum will be eroded. So low inflation and low interest rates improve the outlook for bonds.

Andrew Jenkins, group leader (fixed income) with Fidelity, agrees that it is a good time to buy corporate bond Peps. "Our analysis shows that, over time, diversified portfolio corporate bonds out-perform government bonds," he said.

There is still heavy demand from investors. Pension provision increases weighting in bonds and as few gilts (government bonds) are being issued, companies are issuing bonds to fill the gap. It is also more tax-efficient to raise bonds relative to equities.

The new high-yield funds look to buy bonds in corporations with a lower investment rating than those acceptable in a traditional corporate bond PEP. As Mr Spreadbury explains: "These high-income bonds are one step up from equities, something of a hybrid between bonds and equities."

Tessa Murray at M&G explains why these high-yield bonds (which have been hugely successful in the US) are rapidly being made available to investors in the UK.

She said: "They have lower credit rating and higher yields. Through stringent and active management, we intend to pick the bonds that will achieve a credit rating improvement and hence a capital gain.

"The reason these bonds pay such high yields is because of a perceived risk of default. Default can just mean a bond misses one coupon (interest payment) which may be made up later."

But how likely are bonds to default? Past performance in the US shows that only 3 per cent have defaulted.

"We are convinced that investors in this new market are hugely over-compensated for perceived risks that are not borne out by reality," Ms Murray commented.

Contacts: Fidelity, 0800 414171; Framlington, 0345 775511; M&G, 0800 390390; Schroder, 0800 002000.

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