Is it true bonds have more fun?

PERSONAL EQUITY PLANS Should you choose shares or corporate bonds? We answer the key questions
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Q: So where do these corporate bond PEPs we have heard so much about in the last three months fit in?

A: PEPs invest in shares in companies, which pay dividends out of profits. Profits and dividends rise and fall, and so do share prices. But companies also raise money by issuing bonds, which pay a fixed rate of interest, which is often 50 per cent more than the dividend on shares of the same value, and the interest on bonds takes precedence over the dividend on shares.

Q: So bonds are better than shares then?

A: As I was saying, shares rise and fall, but over the years they tend to rise further than they fall. Bonds will also rise and fall in value. But as they earn a fixed rate of return, they go up when inflation and interest rates generally fall, and they fall when inflation and interest rates rise. They are certainly more vulnerable to inflation than shares, and there is no inbuilt tendency to rise rather than fall over the longer term.

Q: So which should we go for, share or bond PEPs?

A: Share-based PEPs will probably be best for long-term tax-free capital growth. Corporate bond PEPs will be best for tax-free income, certainly over the next three or four years. They should appeal to higher-rate taxpayers and better-off pensioners.

Q: How do they compare with banks and building societies?

A: Bond PEPs will earn 2 to 3 per cent a year more than a Tessa, 3 to 5 per cent more than an ordinary bank or building society account.

But there is virtually no risk of loss with banks and building societies. And deposit rates will rise if inflation returns. There is a real element of risk in bond PEPs. You could lose capital in a bond PEP, especially if interest rates rose.

Q:What can I expect to earn on a bond PEP?

A: Each fund is advertising a target rate of return. See the separate article on how to compare yields. They already vary according to what kind of bonds are included in a bond PEP, and the range on offer so far is anything between 7 per cent and 9 per cent, tax-free.

Q: Why so broad a range?

A: Well, for one thing the element of risk varies. Some companies, such as BT, British Gas or Glaxo, are solid as a rock, others, such as Queens Moat, the hotel company that nearly went bust two years ago, are, well, riskier. Also, some bonds issued years ago pay high annual interest, others more recent pay less, some mature sooner than others, and bond prices and, therefore, yields reflect these differences. Some managers also plan to invest in government bonds, which yield less than bonds issued by companies.

Q: How will we know how our PEPs are doing? Is there anywhere prices are quoted?

A: Many PEPs will be invested in an existing unit trust or an investment trust, and they are already listed in the financial pages. New funds created specially for corporate bond PEPs will also be listed and you will also be able follow them in the financial pages on a daily basis.

Q: How long will my money be tied up for?

A: There is no fixed limit, although you could lose out if you pull out when interest rates are higher than when you started.

Q: What about charges?

A: Simple question, complicated answer. They vary enormously, with combinations of initial charges, annual management charges, and, in some cases, charges for early exits. See our separate article for details.

Q: So how do we apply?

A: Some PEP providers are hoping financial advisers will bring them business. But be careful, they will probably be providers with high initial charges, which help pay commission to the advisers.

Others are relying on leaflets in branch offices, or on coupons in newspapers and magazines, which offer information helplines or information packs and application forms.

Q: Should I apply now?

A: Some providers are offering lower initial charges to investors who apply quickly. But there is no particular hurry. There are almost 40 different bond funds on offer already and some providers, such as S&P and Virgin Direct, say they are deliberately waiting to see what else is on offer.

The levels of inflation and interest rates are unlikely to change much between now and next March. Investors are still limited to a maximum pounds 6 000 of PEPs in a single financial year, plus pounds 3,000 in a single company or single bond fund, so there is something to be said for waiting and seeing.