This plan has a sting in the tail

Corporate bond PEPs look an exciting buy but, writes Jean Eaglesham, they should be handled with care

Do you want a tax-free income that is roughly double that on offer from many high street banks and building society savings accounts? Judging by the money flooding into corporate bond personal equity plans (PEPs), the answer is often "yes".

But anyone thinking of switching money from a savings account into a bond PEP should beware of thinking that the PEP is just as safe, even if it does appear to be guaranteed.

Take, for example, the only packaged bond PEP on the market, which offers a "secured return". The Double-7 Chip plan from Johnson Fry offers a 7 per cent income with your initial investment returned after six years.

So far, so good, apparently. But if, for any reason, you withdraw your money before October, 2002, the end of the six-year term, you could well get back less than you invested. This is particularly a risk if (as is likely) interest rates rise in the meantime.

The reason for this lies in the way that corporate bonds work. These bonds are essentially IOUs issued by companies to investors. The company says it will pay a fixed rate of interest until the bond matures, at which point it will repay the face value.

Between the date of issue and the date when the bond matures, its price fluctuates in line with interest rates. A 1 per cent rise can knock 10 per cent or more off the price of the bond, so if you had to cash in the Johnson Fry PEP when interest rates were high, you could lose a lot of your initial investment.

There is another risk with the Chip plan, albeit a small one. As Graham Hooper, an investment manager with Chase de Vere, an independent adviser in Bath, points out: "Although Johnson Fry has issued a series of almost identical schemes over the last year or so, there is a risk that the Revenue could act retrospectively and withdraw their PEP tax-free status".

This is because the Chip plan uses debt issued by building societies and banks to back up its guarantee, despite the fact that the rules on corporate bond PEPs specifically prohibit these types of financial institutions being included in the plan. The Revenue appears so far to have gone along with the financial engineering used by Johnson Fry to get round this restriction but this may change.

These caveats aside, though, the Chip plan is certainly safer than most corporate bond PEPs, where neither your income nor the value of your capital is guaranteed. However, as with all guarantees, this security carries a price. The 7 per cent income is below that offered by most corporate bond PEPs.

What is more, as with all bond PEPs, the quid pro quo for getting such a relatively high income is that you lose in terms of future growth potential what you gain in income now.

Bond PEPs should only be considered by investors who need a high income now; investors who can get by with less income are likely to be better off sticking to funds that invest in equities.

In the case of the Johnson Fry Chip, for example, the effects of inflation mean that the promise to return your capital intact after six years is, in effect, a promise that your capital will be worth less in real terms then than it is now. If, for example, inflation averages 3 per cent over the next six years, every pounds 1,000 invested now will have the equivalent spending power of pounds 833 by the time the plan ends in 2002.

Last summer Legal & General raised pounds 130m with a guaranteed bond PEP offering a 7 per cent fixed income, with the return of original capital after five and a half years. Earlier this year, Sun Alliance offered its bond PEP investors the option of guaranteeing the return of their capital in six years in return for an extra 5 per cent charge. But few fund managers have followed in these footsteps.

For investors looking for this kind of a deal there are various options. One to consider, which will not use up your annual pounds 6,000 general PEP allowance, is to invest in a Tax-Exempt Special Savings Account, or Tessa. Fixed rates of up to 7.5 per cent are available on these accounts, which guarantee the return of your money at the end of the five-year term provided you do not touch the capital in the meantime. There are, however, restrictions on the amount of money that you can invest.

q For full details of corporate bond PEPs, call Baronworth Investment Services on 0181 518 1218.