Race to provide bond PEPs: runners, risks and rewards

PERSONAL EQUITY PLANS

THERE is already a wide choice of bond PEPs available. For most investors, the choice of provider/ manager will be determined by the annual income, but risks and possible capital gains should also influence choice.

The range of target yields being advertised in the first round of bond PEP launches ranges from a modest 5.7 per cent from Framlington's Convertible Trust PEP, which offers prospective capital gains when converted into shares, up to a high of almost 9 per cent on Commercial Union's Monthly Income Plus PEP, which has a higher risk of capital erosion .

Competition will be severe, and cynics say that it will not be long before someone offers a prospective 10 per cent yield, and some providers will produce high-risk, high-yielding bonds similar to the junk bonds which took the US by storm in the 1980s.

Risks

There is some risk that individual companies issuing bonds will default, and investors will lose everything. Bonds issued by Barings Bank are frequently cited as an example. Individual bond prices and yields will reflect that risk, which can change with the issuing company's circumstances. But the main threat to investors with portfolios of bonds in their funds comes from inflation, which is especially liable to affect bonds with a long life and low interest payments, and the changing levels of interest rates in the economy as a whole. Falling interest rates will make fixed-interest bonds attractive, but rising interest rates will drive down the value of all fixed-interest bonds.

Yields

The return on money invested in a corporate bond PEP comes mainly from the annual interest paid out on the bonds/ stocks. But there is also a possibility of capital gains or capital losses once the bond has been issued, depending on what happens to interest rates along the way and on the difference between the purchase price of the bond and the price at which it will be redeemed. So there are two ways of calculating the return on the investment, one based on the income, the other on the income and capital combined.

To be eligible for inclusion in a PEP, bonds must have a fixed "coupon" which describes the amount of interest paid each year on each pounds 100 nominal of stock. If the stock sells at less than its nominal value, the true yield on the investment will be higher than the coupon. So a stock issued at pounds 100 with an 8 per cent coupon yields 8 per cent on an investment of pounds 100. At, say, pounds 97.50, an 8 per cent coupon will give a "running" yield (also known as a "flat" or an "income" yield) of 100/ 97.5 x 8.00 which works out at 8.205 per cent on each pounds 100 actually invested.

If competing interest rates rise to, say, 9 per cent, an 8 per cent coupon will look less attractive and the value of the stock will tend to fall to 100 x 8/9 = pounds 88.89.

It is unlikely to be quite that sensitive, especially if it is a stock due to mature at pounds 100 in a few years' time, but the price will certainly fall. Conversely, a drop in interest rates will push up the value of a fixed-interest stock and create a capital profit for the holder.

Once a fixed-interest bond has been bought, the investor has locked in the running yield for as long as he or she holds the bond. Once issued, however, the subsequent value of the bond when it is bought and sold on the stock market will rise and fall with supply and demand, and new buyers will receive a different running yield. The yield on a managed portfolio will also fluctuate as the managers trade assets and invest new money.

Bonds eligible for bond PEPs must also have a fixed life or maturity date, set at the time they are issued, after which they will be redeemed at par (ie, their nominal value). If the stock is issued or is currently trading below its par value, it will make a guaranteed capital gain when it matures. Conversely, if it trades above its par value during its life, (usually because short-term interest rates have fallen) it will still be redeemed at par and will inflict a capital loss on the investor who holds it to maturity.

These built-in gains or losses between the current price and the redemption price are averaged out over the remaining life of the bond and added or subtracted to the running yield to produce a "redemption yield". Bonds trading at a price above par will have a higher running yield than their redemption yield; stocks trading below par will have a higher redemption yield.

Shrewd investment in longer-dated maturities can generate bigger gains than in shorter maturities, but the risks of the capital being eroded by inflation and high rates are also greater.

Charges

The actual return to the investor will be affected by the charges the managers impose as well as by the running and redemption yields on the portfolio. Johnson Fry, Legal & General, and M&G make a point of not making an initial charge in order to tempt investors into their funds, although M&G is imposing an exit fee of 4.5 per cent on investors who pull out in the first year, scaling down to 4 per cent in the second year, and on down to zero after five years.

However, most of the pro-viders that have already launched their products are making an initial charge of between 1.5 and 5 per cent, deducted from the initial investment. High charges usually signify high commissions.

The overwhelming majority of providers impose an annual charge, anything from 0.5 per cent at Allied Dunbar to 1.5 per cent at Commercial Union, for their services in managing their funds.

Most managers deduct this charge from the dividend income, which will significantly reduce the running yield. Others tend to pay over the dividends in full - to bolster the running yield - but will deduct the charge from the capital value of the investor's holdings. Over time this could cut the value of the fund significantly.

Autif, the trade body which supervises the sector, is pressing corporate bond PEP managers to make the impact of their charges clear by quoting the running yield and the redemption yield, both net of charges and gross, on the bonds they offer. But there are signs that managers will try to emphasise the yield which most flatters their product and helps it achieve its advertised objective.

o Autif has produced a fact-sheet, available free from: The Unit Trust Information Service, 65 Kingsway, London WC2B 6TD.