A more constant return

Eighteen months ago, tax rules were changed to allow the introduction of corporate bond PEPs, a new investment opportunity under the tax-free umbrella. These plans represent a much lower risk than a general equity- based PEP as they invest in fixed-interest bonds and other securities.

The key point about such investments is that their returns are constant - unlike equities, where returns depend on stock market performance. For that reason they are often aimed at people who have shied away from PEPs, preferring the relative safety of a building society or bank.

Corporate bond PEPs can be ideal for those looking for high income with no need for capital growth, but it would be a mistake to underestimate the risks attached to this type of investment.

In effect they are fixed-interest bonds issued by companies to raise money. The companies pay interest on their 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 paid back. Convertibles, which are also allowed in a corporate bond PEP, are similar vehicles in that they offer a fixed rate of interest, but they also offer 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.

Corporate bonds and convertibles are generally bought by fund managers so private investors can join the game through these managers' unit trusts. It's a game worth playing as yields, the return you get from your investment, can be 7-8 per cent with corporate bonds, compared with 3-4 per cent with equities.

There are often two yields quoted on corporate bond PEPs: the running yield and the gross redemption yield. The first relates to the current estimated level of income you can expect from the fund, but this can be misleading because it takes no account of any capital gains or losses. The second figure gives a better indication of the return on your investment as it takes into account gains or losses on capital, as well as income.

Comparing the redemption yield with the running yield may, in fact, 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 be taken into account. This is because charges have a much greater effect on corporate bond PEPs than general PEPs as your capital is unlikely to be growing.

There is a handful of companies that make no initial charge on one or more of their corporate bond PEPs. They include Fidelity, Guinness Flight, Jarvis, M&G, Save & Prosper, Sun Alliance and Virgin Direct. However, not all of these PEPs are particularly highly rated by the experts.

The Allenbridge Group, a firm of specialist performance analysts, rates corporate bond PEPs according to the level of income offered, allied to fluctuations in the market value and in conjunction with the underlying yield. Its three top-rated funds are the Barclays Unicorn Income Manager, Commercial Union PPT Monthly Income Plus and HTR Preference and Bond.

The Independent is offering a 'Free Guide to PEPs', written by Steve Lodge, personal finance editor at The Independent on Sunday. The 32-page guide, sponsored by GA Life, is available by calling 0500 125888, or filling in the coupon on page 30.