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Bonds - dare you accept the risk?

IN these hard times for savers, any promise of 8% annual income - tax-free - sounds too good to resist. It could yield four or five times the money earned, after tax, on a building society account.

But this is the widely advertised figure which is being used to promote corporate bonds with only days left before the end of ISA (Individual Savings Account) allowance for tax year 2002/3 on April 5. The interest offered leaves banks and building societies far behind, while the risk appears to be much lower than shares.

Corporate bonds are issued by companies to raise money more cheaply than by borrowing from the bank. They are traded on the market, pay interest and return the original capital paid for them on maturity.

All this, of course, depends to some extent on the financial health of the company concerned - so bonds are graded on reliability from 'investment' (sound) to 'non-investment' or junk (much more risky). Riskier bonds, naturally, pay higher interest rates, reflecting added dangers for investors.

For income seekers, corporate bonds are becoming the ballast to anchor personal portfolios in turbulent times. The standard advice is to hold your age in bonds; a 45-year-old should hold 45% of a portfolio in bonds, a 55-year-old 55%, and so on.

On retirement, most of an individually-held savings pot outside the pension should be in bonds - to avoid the sort of stock market rout seen in the last three years.

The fund management arm of Legal & General is urging investors to 'play safe' by buying corporate bonds as an alternative to wasting their ISA allowance altogether.

Its Corporate Bond ISA, made up from investment grade bonds and some gilts (Government bonds) promises 5.33% per annum. To hit the headline figure of 8%, you must buy a High Income ISA invested in higher risk bonds.

In the current year, says L&G, cautious investors will pump more than pounds 1,000 million into its safer product based on mainstream bonds - and perhaps pounds 350 million into the riskier High Income ISA.

At Invesco Perpetual, another fund manager which is a major player in the sector, chief executive Mike Webb says: "Corporate bonds are some of the biggest selling funds this ISA season. But savers need a balanced portfolio with assets allocated in a sensible way in terms of equities versus bonds."

Obviously, corporate bonds have become a vital part of the savings market. The sterling-denominated corporate bond market has grown from pounds 14bn in 1990 to more than pounds 250bn today.

Within an ISA, corporate bond funds pay interest free of tax. If funds hold more than 100 different bonds, the impact should be limited when big name companies like Cable and Wireless and Marconi suddenly hit trouble.

However, this concept of the bond fund worries David Cassidy at Nelson Money Managers: "People are switching to bonds for fixed income for a fixed period with fixed return of capital on maturity," he says.

"But bond funds are really unit trusts, buying and selling bonds at various prices with no single maturity date. Investors therefore don't get a specific date for the return of their capital, because maturity rates differ - and we learned in the 1970s that bond prices can be as volatile as equities."

Nelson's answer is to use an ISA wrapper to put investors into a handful of chosen funds - probably four for a pounds 7,000 investment in safe-yield companies like Vodafone, BOC and Transco - with a minimum five years to go to maturity. On maturity, the money can stay inside the ISA to purchase further bonds, or be taken as cash.

Brian Dennehy, of financial advisers Dennehy Weller, is also wary of the sudden bond boom. In pursuit of income, he fears, investors may risk their capital.

"There are risks to corporate bonds at this stage in the financial cycle," he says. "Interest rates might start to rise, causing bond values to fall as holders get back into cash.

"Secondly, the risk of deflation - falling prices and asset values and vanishing corporate profits - is marginally greater today than it was, say, 20 months ago.

"Few advisers explain how devastating a period of deflation could be. Despite the low-risk aura, many bonds would not provide a hiding place as those which survive would be sharply downgraded, and capital prices will fall steeply."

Dennehy believes the safer investment could be equity income funds - holding shares in companies paying reliable dividends and also suitable for an ISA wrapper.

He likes Jupiter Income, Liontrust First Income, Credit Suisse Monthly Income and, particularly, the Protected Newton Higher Income Plan - which guarantees the original capital.

Clearly, there is something to be said for spreading risk with investments. But corporate bonds are more complex than Premium Bonds - and an Invesco Perpetual survey showing that one in two investors do not know the difference between bonds and shares may be a useful 'wake-up' call.
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Publication:Wales On Sunday (Cardiff, Wales)
Date:Apr 6, 2003
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