Personal Equity Plans: Beware plans that promise big yields

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The Independent Online
INVESTORS seeking a regular income are often deluged with PEPs called High-Yielding, Extra Income or Extra High Yield. But the golden rule is that if the income yield looks too good to be true, it probably is.

The yield expresses the income paid on your investment. "PEPs may advertise yields of 8 per cent or more, but this may be achieved by sacrificing capital growth," warns Roddy Kohn, of Bristol-based financial advisers Kohn Cougar. "Investors should look for maximum running yield of 6 to 7 per cent if they want to preserve capital for the longer term."

Corporate bond PEPs have been pushed hard as income generators. Corporate bonds are loan stock issued by companies to raise cash. Investors receive a fixed payment of interest from the company, usually every six months. At the end of the bond's life they get their money back.

There are around 70 PEPable unit trusts which invest in these fixed-interest securities. Mr Kohn favours M&G's offering of a running yield of 6 per cent. "Over the last three years M&G's corporate bond PEP has provided a total return - income plus growth of the original investment - of 143 per cent," he says.

Some funds include another type of loan stock, preference shares. These also pay a fixed income but are behind corporate bonds in the queue to be repaid if a company is wound up. Because of this, preference shares tend to pay a slightly higher yield than corporate bonds.

Commercial Union's Monthly Income Plus offers a mix between preference shares and corporate bonds and is recommended by Graham Bates of Bates & Partners, independent financial advisers based in Leeds. "It has a yield of around 7 per cent and has a very good track record. The manager of the fund is a real expert in the fixed interest market. It can also provide a little capital growth although that is not its objective."

More aggressive is the Dresdner RCM Preference PEP that invests solely in preference shares. This doesn't aim for a particular yield, but for an income of 9.6p for each unit: at the current unit offer price of 164.3p, a gross yield of 7.4 per cent.

Income investors should not ignore ordinary shares in the search for income, although Mr Kohn believes bonds will be an important defence against volatility in an investment portfolio over the next year.

Equity income funds will take a hit next year, as the tax that can be reclaimed on income will fall from 20 to 10 per cent. Bonds can still reclaim the full 20 per cent. However, the capital growth potential of equity funds should compensate.

Indeed, although yield figures are important, Mr Kohn believes investors should focus on the total return from a fund. "For example, I would prefer to invest in the Foreign & Colonial Investment Trust with a 2 per cent yield but strong capital performance, than Govett High Income which is yielding 7 per cent but showing a capital loss since its launch four years ago."

Rather than looking for a customised income fund with a regime of half- yearly or quarterly pay-outs, Mr Kohn believes investors can get a good income by identifying a good growth fund and then "capital stripping" - that is, cashing in units as and when they need money. "The advantage of this is that if they are investing outside a tax shelter like a PEP or ISA, the income can still be tax efficient as it will be charged to their capital gains allowance not income tax."

For this reason he also favours zero dividend preference shares, a class of split-capital investment trust share, which pay no income during their life, only a pre-agreed capital gain when the trust is wound up, provided the trust assets have grown sufficiently. For example, Fleming Income & Capital launched in March 1992 and issued zeros at 30p each. In March 2002, holders should receive 85.2p per share, a return over the 10 years of 11 per cent.

Many split capital trusts which offer zeros are due to be wound up around 2002, although many will vote to extend the term, at which point zero holders can take their cash or roll over their shares for a new term. Details of investment trusts offering zeros are available from the Association of Investment Trust Companies.

q Contacts: Dresdner RCM, 0800 317 573; Association of Investment Trust Companies, 0171-431 5222.

q Juliet Oxborrow is editor of `Personal Finance' magazine.

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