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.

Start your day with The Independent, sign up for daily news emails
Voices
There will be a chance to bid for a rare example of the SAS Diary, collated by a former member of the regiment in the aftermath of World War II but only published – in a limited run of just 5,000 – in 2011
charity appealTime is running out to secure your favourite lot as our auction closes at 2pm tomorrow
News
Claudia Winkleman and co-host Tess Daly at the Strictly Come Dancing final
people
Arts and Entertainment
Caroline Flack became the tenth winner of Strictly Come Dancing
tvReview: 'Absolutely phenomenal' Xtra Factor presenter wins Strictly Come Dancing final
News
Elton John and David Furnish will marry on 21 December 2014
people
PROMOTED VIDEO
News
people
Life and Style
A still from the 1939 film version of Margaret Mitchell's 'Gone with the Wind'
life
Arts and Entertainment
J Jefferson Farjeon at home in 1953
booksBooksellers say readers are turning away from modern thrillers and back to golden age of crime writing
Sport
Amir Khan is engaged in a broader battle than attempting to win a fight with Floyd Mayweather
boxing Exclusive: Amir Khan reveals plans to travel to Pakistan
News
Stacey Dooley was the only woman to be nominated in last month’s Grierson awards
mediaClare Balding and Davina McCall among those overlooked for Grierson awards
Voices
Joseph Kynaston Reeves arguing with Russell Brand outside the RBS’s London offices on Friday
voicesDJ Taylor: The great tradition of St Paul and Zola reached its nadir with a worker's rant to Russell Brand
News
Twitchers see things differently, depending on their gender
scienceNew study shows that birdwatching men have a lot in common with their feathered friends...
News
i100
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Carlton Senior Appointments: Private Banking Manager - Intl Bank - Los Angeles

$200 - $350 per annum: Carlton Senior Appointments: Managing Producer – Office...

Carlton Senior Appointments: San Fran - Investment Advisor – Ind Advisory Firm

$125 - $225 per annum: Carlton Senior Appointments: San Fran - Investment Advi...

Sheridan Maine: Commercial Finance Manager

Up to £70,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

Sheridan Maine: Regulatory Reporting Accountant

Up to £65,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

Day In a Page

The week Hollywood got scared and had to grow up a bit

The week Hollywood got scared and had to grow up a bit

Sony suffered a chorus of disapproval after it withdrew 'The Interview', but it's not too late for it to take a stand, says Joan Smith
From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?

Panto dames: before and after

From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?
Thirties murder mystery novel is surprise runaway Christmas hit

Thirties murder mystery novel is surprise runaway Christmas hit

Booksellers say readers are turning away from dark modern thrillers and back to the golden age of crime writing
Anne-Marie Huby: 'Charities deserve the best,' says founder of JustGiving

Anne-Marie Huby: 'Charities deserve the best'

Ten million of us have used the JustGiving website to donate to good causes. Its co-founder says that being dynamic is as important as being kind
The botanist who hunts for giant trees at Kew Gardens

The man who hunts giants

A Kew Gardens botanist has found 25 new large tree species - and he's sure there are more out there
The 12 ways of Christmas: Spare a thought for those who will be working to keep others safe during the festive season

The 12 ways of Christmas

We speak to a dozen people who will be working to keep others safe, happy and healthy over the holidays
Birdwatching men have a lot in common with their feathered friends, new study shows

The male exhibits strange behaviour

A new study shows that birdwatching men have a lot in common with their feathered friends...
Diaries of Evelyn Waugh, Virginia Woolf and Noël Coward reveal how they coped with the December blues

Famous diaries: Christmas week in history

Noël Coward parties into the night, Alan Clark bemoans the cost of servants, Evelyn Waugh ponders his drinking…
From noble to narky, the fall of the open letter

From noble to narky, the fall of the open letter

The great tradition of St Paul and Zola reached its nadir with a hungry worker's rant to Russell Brand, says DJ Taylor
A Christmas ghost story by Alison Moore: A prodigal daughter has a breakthrough

A Christmas ghost story by Alison Moore

The story was published earlier this month in 'Poor Souls' Light: Seven Curious Tales'
Marian Keyes: The author on her pre-approved Christmas, true love's parking implications and living in the moment

Marian Keyes

The author on her pre-approved Christmas, true love's parking implications and living in the moment
Bill Granger recipes: Our chef creates an Italian-inspired fish feast for Christmas Eve

Bill Granger's Christmas Eve fish feast

Bill's Italian friends introduced him to the Roman Catholic custom of a lavish fish supper on Christmas Eve. Here, he gives the tradition his own spin…
Liverpool vs Arsenal: Brendan Rodgers is fighting for his reputation

Rodgers fights for his reputation

Liverpool manager tries to stay on his feet despite waves of criticism
Amir Khan: 'The Taliban can threaten me but I must speak out... innocent kids, killed over nothing. It’s sick in the mind'

Amir Khan attacks the Taliban

'They can threaten me but I must speak out... innocent kids, killed over nothing. It’s sick in the mind'
Michael Calvin: Sepp Blatter is my man of the year in sport. Bring on 2015, quick

Michael Calvin's Last Word

Sepp Blatter is my man of the year in sport. Bring on 2015, quick