The yield sounds good, but are you a gambler?

A new-style corporate bond promises glittering rewards, reports Isabel Berwick

MOST OF the fresh ideas we see in the UK turn out to be American imports. The latest concept to cross the Atlantic is the chance to earn a projected 9 per cent a year, tax-free, in a PEP (or ISA). The returns come from a riskier breed of corporate bonds, issued to raise cash for large companies (see the article below for more on how the system works).

Until now, UK corporate bond funds have put investors' cash into bonds from companies with a very strong credit rating. Marks & Spencer has an AAA credit rating - the same as the Government's bonds. But American investors can buy bonds with a lower rating, generally BB and B (see box). These bonds carry increased risk, reflected in their interest rates of 10 per cent and above.

M&G's director of global fixed-interest funds, Dr Theo Zemek, is the first UK manager to put together a corporate bond PEP fund which gives investors here the chance to buy very high-yielding UK bonds. She says: "We are hoping to outperform our advertised 9.5 per cent return. Why is it so high? You get 14 per cent because there is a perceived risk of default, rightly or wrongly. Most people think default means you lose every penny. But in corporate bonds, in most cases, you'd get all or most of the money back. And the default rate on sub-investment grade [riskier] bonds in the USA over the last 20 years has been 2 to 3 per cent. You are over-rewarded for taking risks."

Dr Zemek and her team will approach bond selection in the same way as an equity fund manager, and will use M&G's equity research resources.

The M&G launch is the first of its kind but it believes other big management houses are likely to follow its example in the near future. Long-term interest rates are falling, which means savers get lousy rates, and world stock markets may well be entering a long bear run. Given these factors, a fund offering potentially double-digit returns is likely to have widespread appeal.

But other bond fund managers are cautious about recommending such high- yielding bonds to UK investors at a time when the UK economy is slowing down and there is talk of recession. John Kelly, investment director of BGI (Barclays) funds, says: "Ask yourself whether this is the right time to combine high risk with a relatively high interest rate scenario. Sensible investors will time their investments. Are the signals such that you want to take a risky position at a risky time?"

You will still get a good return in a traditional corporate bond fund. Commercial Union's Ruth Clarke says: "We run our fund to produce income for customers with a level of risk we are comfortable with. The capital performance has been staggering, up 20 per cent in the last year and delivering outstanding returns, currently 6.65 per cent."

That income level does not look great in 1998. But the European central bank is predicted to set its rates at 3.3 per cent, which will bring down UK interest rates even if we don't join the single currency. Acting now to lock yourself into a long-term annual return of 6.65 per cent, plus capital gains, is a prudent move.

Contacts: M&G High Yield Corporate Bond PEP, 0800 389 8601; BGI Gilt and Fixed Income PEP, 0181-522 4000; CU Monthly Income Plus PEP, 0181- 686 9818.

credit ratings

The risk-rating companies (the best known of which is Standard & Poor's) study the financial strength of governments and companies to come up with an "at a glance" rating from AAA downwards.

In the US, risk ratings are widely used and understood by investors but the concept is still new to individual investors over here.

The lower you move down the ratings, the higher the yield on these company bonds will be. But the risk isn't likely to be great if you select your company carefully; some of the lower-rating firms in the UK are household names.

So the skill is the same as it is in picking shares: you need to find an undervalued company with a good management and financial record. If you are lucky, your chosen companies will be re-rated upwards, giving you more security and making the bond's capital value rise.

If not, the rating will stay the same or even slip further downwards.

Rating Borrower Yield on the

bonds %

AAA 10 Year Gilts 5.3

(UK Treasury)

Marks & Spencer 5.6

AA Halifax 5.9

A British Gas 6.5

BBB London Electricity 7.0

Scottish Life 7.0

BB Orange 7.5-10

B William Hill 10-14

HMV 10-14

Colt Telecom 10-14

Source: M&G