Tax-Free savings: Do bonds have more fun?

If you're thinking of investing in a corporate bond fund ISA, watch out. Some fund managers have a trick or two up their sleeves.

A number, including Perpetual, Schroders and Barclays BGI, make charges against the capital rather than the income. This means they can boost the headline yield.

Most corporate bond funds have annual management charges of up to 1 per cent. When values are rising, it does not much matter how charges are taken. Come a setback, it is your capital that is at risk, as these groups will still be taking their fees.

Funds that invest overseas also pose a higher risk. An investment in Russian bonds, for example, would have produced disastrous returns after the country defaulted on its loans last summer. So corporate bond funds are not risk-free. They invest in loan stock, debentures, Euro-bonds, preference shares and convertibles issued by companies raising money and pay a fixed rate of interest until they are redeemed at a set date. So don't expect a rising income over time as with an ordinary income fund.

When looking at a fund, look at redemption yields as well as running yields. The running yield shows only the annual income you will receive from the bonds as a percentage of the money you invest, the redemption yield also includes any capital gains or losses if you hold the bonds until they are redeemed.

Any loan stock is only as good as the company issuing it. So you can expect the yield on BT or Glaxo-Wellcome's loan stock to be lower than that of a small engineer.

The big fear is that a company may go into default, that is, not pay the interest. Tessa Murray, of M&G, says: "Over the long term, 20 years or so, around 3 per cent of companies default each year. But this doesn't mean that you lose all your money, even if they go bust. As a bond holder, you stand much higher up in the pecking order."

While most of the funds invest in companies with top credit ratings, a number offer much higher yields of 7 or even 8 per cent by investing in so-called junk or sub-investment grade bonds.

"There can be higher risks," admits Ms Murray, "but there are often complicated reasons why a company can have a low credit rating. Many new companies and those expanding rapidly, such as the telecoms, have bonds with high yields. For example, Orange - the mobile phone company - is yielding 8.6 per cent, while HMV Media, the record stores, Coral, the betting shops, and Welcome Break, the motel chain, also have yields over 8 per cent."

Others are not so sanguine about these funds. "They're OK so long as the investor is aware of the risks," says Hugh Everitt, manager of CGU's fixed interest funds. "Higher yields are generally offered by highly geared and immature companies. At the moment, the economic environment is friendly towards them. If it changes, the market in these bonds can turn very volatile. While you can always buy them, you can't always sell them."

You can put up to pounds 7,000 into a corporate bond fund this year, falling to pounds 5,000 next year, through a maxi ISA, or pounds 3,000 in a mini ISA, with all the income and any capital gains free from tax. The income they earn is from interest payments, so is not subject to the advanced corporation tax that companies pay on dividends.

You can buy a corporate bond ISA directly from the managers, through independent financial advisers, or by using an execution only discount broker.

While you get no advice from the latter, you can make significant savings as most funds levy an initial charge of anything up to 5 per cent. A discount broker will return most if not all of this.