Bonds fill the gap

Emma Weiss reports on the best deal for people who want to balance risk and reward

CORPORATE-BOND personal equity plans (PEPs) have been the biggest story in the unit trust industry for the past six months. They also look set to attract a significant chunk of the money earmarked for PEPs prior to the end of the tax year in April.

These tax-free investments are offered by nearly 30 unit trust managers, and attracted more than pounds 450m of new money between July and December last year. Private investors are attracted to corporate-bond funds because they are able to fill what was something of a hole in the UK investment landscape.

On one side of the spectrum are bank and building society deposits which form the bedrock of personal savings. On the other side is investment in shares, more risky but providing, in the long term, better performance.

Between, investors want and need access to a type of investment which will achieve more than bank and building society deposits, but does not involve as much risk as investing in shares.

The return on deposits has certainly been in the spotlight recently with millions of Tessa savers waiting for their accounts to mature. Some Tessa savers will be disappointed at their final payout after five years of committed saving. They have watched rates fall from the 14 per cent offered by many Tax-Exempt Special Savings Accounts at launch to the current 7 per cent or so. Some of these savers may well now wish that they had been prepared to take a riskier strategy five years ago.

The message for Tessa savers now should be that any investor who is prepared to take a five-year view should consider the options carefully. It is never wise to put all your eggs in one basket, but working on the basis of a healthy minimum kept in the safety of bank or building society deposits, it may be worth getting some money to work harder in either a corporate- bond PEP or an equity PEP.

PEPs are popular because the interest received as income, or the growth within the plan itself, are free of tax. There is no capital gains tax to pay on the sale of a PEP. The maximum that can be invested in a PEP in any one year is pounds 6,000, plus a further pounds 3,000 in a single-company PEP.

Corporate bonds themselves are not new. Bonds, simply another name for loans, have been around since the dawn of capitalism. The best known are gilts, which are bonds issued by the government. Corporate bonds are issued by companies in order to raise money.

In his November 1994 Budget, the Chancellor, Kenneth Clarke, extended the rules governing tax-efficient PEPs to embrace corporate bonds as well as equities. The ethos is two-pronged: to provide companies with a whole new source of finance, and to allow private investors easier access to the bond market.

Low inflation and falling interest rates have depressed the rates of return on deposits, and the income produced by bonds has fallen slightly as a result. However, this has meant the value of bonds themselves has risen - yields and prices are inversely correlated (as they are with shares). As a result, since last summer, investors who entered the new corporate- bond PEP market will have notched up an appreciable return on their investment - perhaps 7 per cent.

The annual income from a bond is paid at a fixed rate. The amount of bond income in actual pounds and pence stays the same, but the yield for new buyers changes as the capital value of a bond shifts. In effect, the greater the cost of the bond, the smaller is the income as a proportion of an investment.

If economic conditions are right, corporate bonds can achieve a high comparative total return.

That has been true since corporate-bond PEPs were launched. But the potential downside of investing in corporate bonds should also be clear.

There is no certainty when investing in stock or bond markets and a long- term view is vital to avoid becoming the victim of short-term volatility.

Anyone, therefore, who is saving for something specific in the next couple of years would be best advised to keep it in a bank or building society account or cash unit trust for maximum capital certainty.

q For a free factsheet on corporate-bond PEPs, published by the Association of Unit Trusts and Investment Funds, call 0181 207 1361.

q Emma Weiss works for the Association of Unit Trusts and Investment Funds.