Tax breaks encourage more bonding with big businesses

Corporate bond ISAs give nervous income investors a halfway house between low building society returns and the high risks of the stockmarket.

Corporate bond ISAs give nervous income investors a halfway house between low building society returns and the high risks of the stockmarket.

Corporate bonds are the interest-paying IOUs which big companies issue to raise funds. As with shares, buying your bonds in an ISA shelters your return from both income tax and capital gains tax (CGT).

But, since this April, corporate bond ISAs have enjoyed an extra tax advantage over their equity rivals. Chancellor Gordon Brown's scaling down of dividend tax credits for equity savers cuts the income which shares can give you. But interest-paying investments, such as corporate bonds, remain unaffected by the move.

This means a share investor effectively has 10% tax deducted before his income reaches him, but a corporate bond investor does not. Because this is a corporation tax liability, rather than income tax or CGT, the ISA does not help. Amanda Davidson of London IFAs Holden Meehan, says: "Before this change, there was no difference between a corporate bond fund and an equity income fund from a tax point of view. But, now there is a difference. As part of a balanced portfolio, you should have some money in corporate bonds. And you might as well put the tax wrapper around them, because your income tax breaks are better than with equity income ISAs."

For a basic-rate taxpayer with £5,000 in an ISA paying gross annual income of 5%, choosing corporate bonds would produce £250 income each year. Putting the same money in a shares ISA with the same income yield would produce £225. The gap will widen further in April 2004, when shares lose even the temporary tax credit Brown has left them with. The return in our example above would fall to £200.

Justin Modray of independent ISA experts Chase de Vere, says: "Some of the lower-yielding corporate bond funds and some of the high-yielding equity funds kind of straddle each other towards the 5% figure. That's where it could make the biggest difference. But if someone wants equities, I wouldn't necessarily recommend they avoid them simply because of the tax difference."

If you do decide to go for a corporate bond ISA, be sure to take the "headline" income yields they promote with a pinch of salt. It will always be tempting to pick the fund promising the biggest income, but sometimes these high income yields are achieved only at the risk of capital erosion.

One danger is that the company running your fund will take its management charges from capital rather than income. This gives the fund an apparently attractive income yield, but will also chip away at the value of your capital.

Beware also of corporate bond ISAs which put a lot of your money not into the safe bonds you think you are buying, but into far riskier investments such as preference shares and convertibles. These offer the promise of higher returns than corporate bonds, but could put your capital at risk. A fund can put as little as 60% of its money into bonds themselves and still be classified as a bond fund.

Unlike bonds, preference shares and convertibles rely on dividends rather than interest. In order to qualify for the better tax treatment discussed above, a fund must pump at least 60% of its money into interest-paying investments.

For a free copy of Bates Investment Services' guide to investing for income (normal price £2.60), call 0800 013 4135.

Holden Meehan, 0171-692 1700; CGU, 0171-283 7500; Henderson, 0500 707 707; Fidelity, 01732 777086