The rewards of a little bit of risk

Corporate bonds offer a good compromise for the investor who likes to play fairly safe, says Rachel Fixsen

Continuing nervousness in the UK stock market is leading increasing numbers of risk-averse investors to search for "safe havens" for their hard-earned savings. Many are turning to corporate bonds - seen as safer than equities but higher yielding than deposits or government-backed bonds - as a means of minimising risk.

This strategy carries the approval - albeit not totally disinterested - of some experts. "If [stock] markets are going to sell off a lot you have got some additional protection with bonds," says Mark Gull, investment manager at Gartmore for the NatWest Extra Income Trust - a corporate bond fund.

The stock market certainly has risen strongly. The FT-SE 100 share index hovered this week at around 5,880, up 14.5 per cent since the start of this year and 26 per cent since this time last year. Yet many analysts are now suggesting that a correction is long overdue. So what exactly are corporate bonds?

These fixed-interest instruments take many shapes and forms, but are basically IOUs issued by companies for money borrowed. The bonds pay an annual rate of interest, or "coupon". They are seen as safer than ordinary shares because if a company goes bankrupt, bondholders have to be repaid before shareholders get a look in.

Once bonds have been issued and become securities traded between investors, the face value can go up or down. For instance, the price of a bond might fall if long-term interest rates rise, to keep the return on capital invested in line with market rates. If, for example, a pounds 100 bond paying 5 per cent is sold for pounds 50, then the return doubles to 10 per cent. Or a bond's price might fall if the company that issued it gets into difficulties and there is a possibility it may not be able to redeem the bond.

Corporate bond unit trusts can be held as a personal equity plan (Pep), with the tax advantages that brings, as long as at least 50 per cent of the fund is held in qualifying assets. So within your Pep allowance you could move some funds from equities into a corporate bond unit trust.

Peps as we know them are on their way out, to be replaced in April 1999 with the Individual Savings Account, but most advisers still recommend making the most of this year's allowance. As long as you have less than pounds 50,000 in Peps, you will be able to transfer investments held within them into ISAs when they come in, ISAs are also tax free and terms are similar to Peps.

Bond funds mainly suit people who want their investment to produce an income rather than capital growth. This means retired people in particular. But Ruth Clarke, development director at Commercial Union Trust Managers, says about 60 per cent of business in its Monthly Income Plus unit trust, a diversified corporate bond fund, at the moment is income being reinvested.

"Because there's this issue about whether the market's looking a bit `toppy', there are investors moving into the MIP, treating it as a lower- risk growth vehicle," says Ms Clarke.

But, depending on the asset mix of the fund, there may also be some capital growth if you leave the investment in place for a reasonable period, says Colin Jackson of Baronworth Investment Services. If some of the assets are held in equities, there is likely to be capital growth. And over the last few years there has been some growth in corporate bond values because long-term interest rates have been declining.

Over the last five years, a pounds 1,000 lump-sum investment in the Legal & General Fixed Interest unit trust would have grown to pounds 1,448.79, assuming net income was reinvested. If the same amount had been invested in a UK Gilt unit trust, it would on average have grown to pounds 1,333.59 according to Moneyfacts, the financial information provider.

That money would have done even better, but arguably been at more risk, in an equity income fund where on average it would have swelled to pounds 2,025.74.

Not all corporate bond unit trusts are the same. In many ways they vary far more than equity funds, because of the different types of instrument held within them.

"There is a wide range of risk profiles of these funds," says Mr Gull. For instance, within Pep rules, a corporate bond unit trust could hold much of its qualifying assets allocation in convertible bonds. These are bonds which after a certain date can be converted to ordinary shares in the issuing company. This means they tend to imitate share price movements rather than the government bond market.

And the 50 per cent of assets which do not have to be held as bonds could be held as foreign shares - subject to currency risk on top of stock market risk. So look closely at the composition of a fund before buying units in it. Performance tables will not tell the whole story.

"A lot of the ones you see leading the performance tables do that on the back of a lot of convertibles and preference shares which behave more like equities," says Steve Abbott, marketing director for Legal & General Unit Trust Managers.

Corporate bonds are theoretically more risky than government bonds, or gilts, but in practice issuers are often huge corporations, such as Abbey National. "The chances of defaulting are pretty remote," says Ms Clarke.

One thing to watch out for is that the fund is not using up capital to produce a high-income stream. Look at the running yield, which measures the income as a percentage of the current cost of buying the bond, adds Andrew Bellshaw of Gartmore Extra Yield Fund, and compare this with the redemption yield, which also takes into account how much the bonds can be redeemed for. "If the redemption yield is lower than the running yield you can be fairly confident that you're burning your capital," he says.

Baronworth Investment Services, 0181-513 1219. On request, Baronworth will send readers a free copy of its Corporate Bond Table which compares conditions on more than 60 funds. Legal & General, 01222 448412; Commercial Union, 0181-686 9818.