Investing For Income: Corporate bonds - a capital idea

Interest rates are on their way down - good news for borrowers but not for anyone trying to generate an income from capital. The answer for investors looking for tax-free income could lie in corporate bond unit trusts.

These can be held in a tax-exempt Pep and are based on long-term interest rates, rather than the short-term types that govern savings accounts at building societies.

"If short-term rates come down, then the fact that corporate bonds pay 7 per cent should look quite attractive," says Andrew Jones, of the David Aaron Partnership.

Like government bonds or gilts, corporate bonds are IOUs for money borrowed. They pay a fixed annual return or coupon. But with corporate bonds, the issuer is a company rather than the Government.

Corporate bonds are traded, so their price can go up or down, depending on long-term interest rates and the creditworthiness of the issuer. When the price falls, the yield rises, and vice versa. For example, if a pounds 100 bond with a 5 per cent coupon is sold for pounds 50, then the return effectively doubles.

Bond funds mainly suit investors looking for income rather than capital growth - retired people in particular. But a lot of investors choose the funds to reinvest income.

"If someone wants a steady income with more risk than high- street deposits but a lot less than equities, then it does fill the gap," says Julie Lord, of Cardiff-based financial planners Cavendish Financial Management. "But a lot of clients misunderstand the risk involved," she adds.

Corporate bonds are more risky than government bonds but less risky than ordinary shares. The issuer has to pay holders their coupon even if it cuts dividends on ordinary shares. And if it goes bankrupt, bond-holders will be repaid before shareholders. Holding the bonds in a unit trust rather than directly also minimises the risks through diversification.

Not all corporate bond unit trusts are the same, mainly because of the wide variety of instruments that they can hold. To qualify for Pep status, the funds have to hold at least 60 per cent of assets in corporate bonds. The rest can be held in preference shares, equities or cash, and the mix depends on the fund manager.

Some corporate bonds are riskier than others, depending on the cred- it rating of the issuer. It is fair to assume that the higher the running yield of a corporate-bond fund, the lower quality the bonds it invests in, says Colin Jackson, of Baronworth Investment Services.

Julie Lord recommends the Commercial Union Monthly Income Plus unit trust, which is not invested exclusively in corporate bonds. The fund has a running yield of 6.98 per cent. The Standard Life Premier Income Fund Pep aims for a broad spread of risk and return, she says. Its running yield is 6.23 per cent.

The M&G Corporate Bond Fund Pep currently yields 6.38 per cent and is a low-risk, solid corporate fund, says Andrew Jones. M&G also markets its High Yield Corporate Bond Pep which yields around 8.5 per cent. But investors may be reluctant to take on a higher-risk fund given the economic outlook right now, he says.

When choosing a corporate bond Pep, compare the running yield with the redemption yield, which takes into account how much the bonds can be redeemed for. Other points to consider are how high the charges are, whether they are levied on the capital or the income and the plan manager's track record.

David Aaron Partnership: 01908 281544; Cavendish Financial Management: 01222 665588; Baronworth Investment Services: 0181-518 1219