PEP survey: Geared up for income

Returns on corporate bonds are higher, and risks lower, than equity investments. Simon Read looks at how the youngest member of the PEP family can suit nervous investors

Corporate bond PEPs are the youngest of the PEP range, having been introduced in July 1995. They represent an ideal way to generate a decent income. On top of that, corporate bonds are seen as safer investments than more traditional general PEPs.

Corporate bond PEPs represent a lower risk because they invest in fixed- interest bonds and other securities, such as convertibles and preference shares.

But a lower risk doesn't mean no risk. Corporate bonds are fixed-interest bonds issued by companies to raise money. The companies pay interest on their bonds and repay the capital later on a pre-set date.

If a company goes bust, however, your loan is unlikely to be repaid. In practice, this is unlikely to happen because only blue-chip companies issue corporate bonds.

There is a wide choice of corporate bond PEPs, but what they all have in common is that they are set up to generate income.

Convertibles are used by some managers. They too offer a fixed rate of interest, but they also offer investors the chance to convert their option into shares. For that reason they offer lower returns than corporate bonds. But they do offer the extra potential of enjoying the capital growth associated with equities.

Convertibles have, therefore, often been more heavily promoted as a relatively low-risk entry into the equity market.

Both corporate bonds and convertibles are seldom invested in directly by private individuals. Investors can use the specialist unit trusts on offer from fund managers. It's a game worth playing as yields, the return you get, can be much greater with corporate bonds at 7-8 per cent, compared with 3-4 per cent with equities.

Additionally, corporate bonds are less risky than ordinary shares in that if a company goes bust, corporate bondholders will be paid out before ordinary shareholders. But the risk of losing out is still possible.

There are often two yields quoted on corporate bond PEPs, the "running yield" and the "gross redemption yield".

The first relates to the current estimated level of income you'll get from the fund, but this can be misleading because it takes no account of any capital gains or losses. The notion of capital rising or falling in this type of investment may seem confusing, but that's because while there may be fixed interest on offer, there is no guarantee on capital. Bond prices vary according to the prevailing market conditions and the timing of buying and selling bonds can affect the return.

Gross redemption yield in fact gives a better indication of the return on your investment in a corporate bond PEP as it takes into account gains or losses on capital, as well as income. Comparing the redemption yield with the running yield may, in fact, reveal that the gross return of the fund may fall over time, particularly if the running yield is much higher.

How to choose? Obviously, the yield is something to consider but charges should also be taken into account. This is because they have a much greater effect on corporate bond PEPs than general PEPs because your capital is unlikely to be growing. High charges will therefore erode your capital quite quickly whereas in an equity-linked PEP, the growth should offset the charges effect.