Money: Investing for income - Look before you leap into bonds

INVESTORS seeking income have a dilemma. Despite the recent base rate rises and the keen competition for savers' money, the interest available from most banks and building societies is not making waves. Meanwhile, equities look expensive at the moment, so buying high-yielding shares could put your capital at risk.

Corporate bond personal equity plans (PEPs) might therefore be a good halfway house for income investors. Corporate bonds are issued by companies that need to raise money. You get a regular income from the bonds and it makes sense to hold them in a PEP, where that income is tax free. The planned replacement of PEPs with individual savings accounts (ISAs) shouldn't affect this logic. Corporate bonds held in a PEP will be transferable to ISAs though, as things stand, you won't be able to transfer more than pounds 50,000 worth of assets to these new accounts when they come into being next year.

Tessa Murray, of M&G, says that her company is selling more corporate bond plans than any other type of PEP at the moment. M&G's fund is currently yielding about 6 per cent. As it is tax free, the yield is actually worth about 7.5 per cent to basic-rate and 10 per cent to higher-rate taxpayers.

In theory, there's nothing to stop you assembling your own portfolio of bonds within a "self-select" PEP. But since you can only put pounds 6,000 into a PEP in any one tax year, the danger is that you'll end up with too few different bonds for your portfolio to be sufficiently diversified. For this reason, most investors use a corporate bond fund managed by a PEP provider.

However, choosing between funds may not be easy; there are almost as many on the market as there are corporate bonds.

Before making your choice, don't just go for the highest yield. The figures that fund managers quote can be misleading and, besides, there are other factors to consider. Although the income yield is important, most fund managers also quote a gross redemption yield. This takes into account the income and capital value of the bonds in the fund if they are held to maturity.

Less revealing, but often the headline figure quoted, is the running yield which only takes into account the current rate of income received on the bonds. This figure could mask any threats to your starting capital.

Charges are particularly important when making comparisons. With investments in shares, it's possible to overcome the effect of high charges with superior growth. But corporate bond PEPs tend to show more similar growth, so high charges can be more damaging.

It's also vital to look at how the charges are levied. Some fund managers deduct them from capital rather than income, which artificially inflates the yield available on the fund but means there's a chance of your investment being eroded. Corporate bond PEP managers that deduct charges in this way include Aberdeen, Baillie Gifford, GT and Henderson.

Roddy Kohn, of independent financial advisers Kohn Cougar, says: "The portfolio of a corporate bond PEP is vital. You need to pay attention to the quality of the bonds held by the manager."

In practice, this means looking at two factors. First there's the question of how risky funds are and how likely companies are to default on repaying the bonds. Few funds have credit ratings of their own, so you need to ask managers about the average rating of bonds in their portfolios. Two agencies specialise in analysing the creditworthiness of companies. Anything below a "BBB" rating from Standard & Poor's or a "Ba" rating from Moody's indicates a company that could have difficulty meeting its commitments in certain circumstances.

The second quality factor to consider is the "mean term to maturity". This is the average length of time until the maturity of the bonds in a fund manager's portfolio. In general, the longer a bond has to run, the more volatile its value. As the value of a bond is guaranteed at maturity, the nearer you get, the less likely its price is to fluctuate.

Note, however, that bonds with less than five years to maturity can't be held in a PEP. Typically, corporate bond PEP managers hold bonds with a mean term to maturity of between six and 20 years. Within that bracket, though, there's a lot of variation between the funds.

Another way of looking at the quality issue is to recognise that longer- term bonds and bonds with lower credit ratings usually pay higher incomes, in order to compensate investors for taking more risk.

Many corporate bond PEP managers invest in large numbers of preference shares in order to secure higher yields and some capital growth for their funds. Preference shares are qualifying assets for a corporate bond PEP but tend to be riskier than bonds. If the company is wound up, preference shareholders get their money back before ordinary investors but after the bondholders. So if you're looking for low risk, avoid funds with high preference share weightings.

Finally, remember that you don't have to take the income from a bond PEP; you can reinvest it. Peter Ainsworth, of Guinness Flight, says: "About half our corporate bond PEP holders take the income and half reinvest it. If you don't need income in the short term, this is a pretty attractive investment strategy."