Corporate bonds lead the field for yields

The Recent rise in the popularity of PEPs can partly be attributed to the decision in 1995 to allow corporate bonds to shelter beneath a PEP umbrella. These are seen as much safer investments, although the same rules apply to them as the more traditional general PEPs, in that you can invest up to pounds 6,000 a year and receive profits free of tax.

Corporate bond PEPs represent a much lower risk than general equity-based plans, as they invest in fixed-interest bonds and similar securities. For that reason they are often recommended for people who have previously shied away from PEPs, preferring to keep their savings in the relative safety of a building society or bank. Indeed, corporate bond PEPs can be ideal if people are looking for high income with no need for capital growth. But it would be a mistake to consider this type of investment as risk-free.

To understand the risk, you need to understand the nature of the underlying investments which are held in this type of PEP. Despite the name, the permitted investments are not just limited to corporate bonds but can include convertibles and preference shares as well as other investments. There are around 60 corporate bond PEPs on offer, with a number of different strategies offered by individual managers. What they all have in common is that they are set up to generate income, rather than capital growth.

This comes from the nature of corporate bonds themselves. In effect they are fixed-interest loans to large companies. As with any other type of loan, the companies pay interest on the bonds and repay the capital at a pre-set date. Investors are therefore lending a company money for a fixed time and receiving interest on the loan until it is repaid.

Convertibles are similar vehicles in that, like corporate bonds, they offer a fixed rate of interest but also give investors the chance to convert their option into shares. For that reason they offer lower returns than corporate bonds but do offer the extra potential of enjoying the capital growth associated with equities.

Both corporate bonds and convertibles are seldom invested in directly by individuals. However, individual investors can join the game through the unit trusts run by fund managers. It is a game worth playing as yields can be much greater with corporate bonds, at 7 to 8 per cent, compared with 3 to 4 per cent for equities.

Additionally, corporate bonds are less risky than shares in that if a company goes bust, corporate bondholders will be paid before ordinary shareholders. But the risk of losing all is still possible with bonds and this risk can have an impact on the yield offered. For example, a blue chip such as Marks & Spencer will offer a lower yield than many other companies because there is much less chance of Marks going belly-up.

When comparing yields it is therefore worth bearing the risks in mind. There are often two yields quoted on corporate bond PEPs, the running yield and the gross redemption yield. The first relates to the estimated level of income you will 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 is because while there may be fixed interest on offer, there is no guarantee on capital. Bond prices go up and down and the timing of buying and selling bonds can affect the return. So do not be fooled by advertisements of guaranteed income or yield, which simply hide the fact that your capital may be at risk.

In fact, gross redemption yield 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 could reveal that the gross return of the fund may fall over time, particularly if the running yield is much higher.

How should you choose a corporate bond PEP? Obviously the yield is something to consider, but charges should also play a part in your decision. Bear in mind that charges have a much greater effect on corporate bond PEPs than general PEPs because your capital is unlikely to be growing. High fees will therefore erode your capital quite quickly, whereas in an equity- linked PEP growth should offset the charges.