Bond PEPs are not the be-all and end-all

Individual needs dictate the best income investment. Michael Royd assesses the options

MUCH has been made of the new corporate bond PEP to encourage sales of this new financial product. Unfortunately, there has been much less comment about who should buy it.

The marketing machine suggests that this PEP is an alternative to a building society de- posit. True, the corporate bond PEP will pay a higher rate, but it will not provide the security of capital that building society customers expect.

In the event of a sterling crisis - not beyond the bounds of possibility, given the current political situation, if interest rates rose to 10 per cent - the capital value of the corporate bond PEP might well fall by a quarter. Few warnings are being given about the effect of interest-rate movements, nor any indication of the volatility of bond markets, which has been evident over the past few years.

There are a number of other financial products that provide an alternative to corporate bond PEPs, and they can have significant advantages. They should be considered carefully. It is the needs of the client that should determine the sale of investments rather than the necessity to sell a new product.

Guaranteed income bonds

These may be purchased for between one and five years and provide both guaranteed income and guaranteed return of capital. There is usually no maximum investment and a minimum of pounds 5,000. Investors can achieve yields net of basic rate tax of between 5.5 per cent and 7 per cent with only a small reduction for higher-rate taxpayers.

Lifetime income bond

This is invested entirely in War Loan stock (a UK Government gilt), currently paying a guaranteed 7.7 per cent net of basic-rate tax for life, or joint lives for married couples. It may make an ideal investment for the tax- free cash sum at retirement from a pension. The net yield is the same or better than a pension annuity for normal retirement ages and especially joint annuities. There is minimum investment of pounds 10,000, but no maximum. Income may be paid monthly.

The annuity for a male aged 65, (female 60) is 9 per cent gross or 6.75 per cent net of basic tax. For a male aged 70 (female 65) it is 9.7 per cent gross or 7.3 per cent net. For a 60-year-old male it is 9.7 per cent gross, 7.3 per cent net.

Purchase life annuities

A lump-sum investment is made to provide income for life. The capital is gone for ever, but a high yield is obtained and taxed at approximately half the usual rate, because part of the income is regarded as return of capital. The lifetime income bond provides a higher income up to the age of 60 for women, 55 for men.

The yield for a male aged 55 is 9.5 per cent gross, 8.1 per cent net. For a female aged 60, it is 9.2 per cent gross, 7.9 per cent net.

Equity-based PEPs

There is not that large a margin in income between corporate bond PEPs and some equity-based PEPs to justify the former for younger investors. On an historical basis, the equity-based income will overtake the corporate bond income within a few years, and there is the potential for growth.

Over the last 10 years, the real returns from equities were 12 per cent and from conventional gilts 6 per cent. Very little growth can be expected for corporate bond PEPs if interest rates remain constant. The performance of sterling corporate bonds and gilts is closely linked.

It has been suggested that the use of corporate bond PEPs will provide a spread of risk for UK investors. The evidence is that this may not be true for domestic bonds, but only for overseas bonds. However, this will also depend on interest-rate cycles.

High-income PEPs

Currently available are two high- income PEPs with a guarantee of return of capital and income of 7 per cent net. These products appear attractive, provided the Inland Revenue consents to their use. Remember what happened to guaranteed Business Expansion Schemes.

Tessas

Many readers will have Tax-Exempt Special Savings Accounts yielding around 6.5 per cent to 8 per cent net. It is probably better to keep this money in a Tessa than a corporate bond PEP, as the difference in the yields is small and there is no capital risk to the Tessa.

Cash on deposit

Simply making better use of cash unit trusts, building societies, and Scottish Widows Bank may provide investors with returns of up to 6.9 per cent with instant access accounts.

The choice is wide and depends on the needs of the investor, taking into account tax rates, the amount available to invest, inheritance tax planning, age allowance, attitude to risk, and life expectancy.

q Michael Royd is an independent financial adviser.