Having a Tessa in the family is no longer an option since the arrival of the Isa. But what else is out there for the UK's more risk-averse investors? William Russell investigates
It is estimated that more than £7bn is tied up in tax exempt special savings schemes (Tessas) due to mature during the rest of 2001.
With interest rates falling and stock markets groaning, Tessa savers are facing the dilemma of how best to protect the future value of these savings. This may account for the fact that so many of those whose estimated £14bn worth of Tessa savings have already matured this year have yet to make up their minds as to their next move.
Account holders are being given six months to decide, after which the money will automatically be switched into an ordinary account with the original provider. But these accounts will offer little or no interest and obviously have no tax benefits to speak of. Still, the banks are expecting a mighty slice of such funds, mainly because of one of the traditional strengths of the banking sector ' client inertia.
No time to lose
Of course, delaying the decision will only cost more money in terms of lost investment potential. So what are the options? Much depends on the individual's risk profile and their determination to maintain the money in a tax-efficient environment.
Tessas themselves have always come with restrictions on access if you wanted to maintain the tax-free status. Some of the Tessa-only individual savings accounts (Toisas) that are currently being promoted also impose restrictions while the interest rates are far from enticing.
There is even one Toisa paying less than 5% on small balances. The best is paying around 7% but where the higher rates are available, there are usually restrictions including having to give up to 180 days notice for withdrawals and even then having to sacrifice some of their interest.
Even if you are allowed to withdraw money as and when you like, it has to be noted that once the money is removed from a Toisa it can never be replaced and so the tax-free allowance is lost forever.
There are also limits on how much can be transferred into the new Toisas. Only the original capital is eligible up to a maximum of £9,000 though this allowance is over and above the standard £7,000 Isa allowance. Even so, according to figures collated by Moneyfacts (see Table 1), it means that the average accountholder with a Tessa that matured in January of this year will still have in the region of £2,290 of extra capital to invest.
Alternatives such as cash Isas also hold little attraction in terms of the rates currently on offer or those expected in the near future. But there is another possibility for investors keen to maximise their returns.
Instead of rolling over the capital into a Toisas they could withdraw the total amount accumulated ' both capital and interest ' and reinvest it in a corporate bond fund.
With the income reinvested, this sort of fund could return in the region of 10% per annum on a compound basis. Those with existing cash mini Isas, for example, would also be free to use their remaining stocks and shares mini allowance to shelter such investment. While those who have yet to utilise their annual allowance could invest the first £7,000 of such a sum tax-free.
Knowledge vs risk
Of course, no one is suggesting that such investments are completely risk-free so it is important that investors understand the level of risk involved. This will vary depending on the sort of corporate bond fund chosen, however.
Basically, corporate bonds are the IOUs issued by companies when they need to raise additional finance. At times such as now ' when interest rates are low ' it is a low-cost way to finance expansion and product development costs.
But not all companies are equal in terms of their financial standing. A number of organisations, including Standard & Poor's, credit rate companies and this rating is taken into account when judging a particular company's corporate bonds.
A company with a high standing where there is very little risk of default will therefore have to pay less in terms of interest than one with a more risky profile or that operates in an industry seen as being more volatile.
If a company is rated as BBB or better its corporate bonds are reckoned to be of 'investment grade.' As these companies present relatively little risk in terms of default, the interest paid will be lower, reflecting this risk.
Companies rated below BBB are termed high-yield and pay higher rates of interest to reflect the increased risk.
For example, an AAA rating would be given to a British Government bond and this would be reflected in a current yield of around 5%. A bond issued by the Government of Portugal would receive an AA rating while a company such as British Gas would warrant only an A rating. By the time you reach BBB rated companies like ICI, the yield would be around the 7% mark rising to double-figure returns once you reach B or CCC rated bonds.
The only other risk to consider is the length of time that a bond still has to run until reaching maturity. Common sense tells us that the longer the time until a bond matures, the higher the risk of something going wrong.
Playing the field
For those who were originally attracted to Tessas because they involved minimal risk ' except inflation whittling away their spending power ' the best option in corporate bond terms would obviously be a fund whose portfolio carried only investment grade bonds.
But the price of investment grade bonds will vary in line with interest rate movements. As rates rise, so the price of the bonds will fall and vice versa. Thus there is a potential risk to capital from an increase in interest rates.
But, as James Foster, director of credit strategy and research at RSA Investments, says: 'Because new money flowing into the fund would be invested at the new levels, there should be some compensation in the form of a slightly improved yield. But it's vital that investors realise and accept that there are some risks, however minimal, involved even in an investment grade bond fund.'
Those investors whose income needs mean that they are required to take a higher level of risk or those who already have lower risk holdings such as cash minis or deposit accounts should naturally look toward funds which carry a proportion of high-yield bonds.
Foster says: 'It's our job as managers to monitor the companies whose bonds we hold and try to minimise the risks from a possible default. We also try to select companies we believe will see an improvement in their credit rating in the future. That way we buy into a high-yield and when it comes down we make a capital gain as well.'
Numerous surveys have examined potential default rates on bonds. Although findings differ, it is important to realise that most of such research has been based on US experience which, as Table 2 demonstrates, offers little guidance on bonds that obey UK liquidity guidelines.
The important thing to understand is that very few companies actually find themselves unable to meet their bond commitments and go into liquidation.
For starters, bondholders take pride of place when a company's assets are distributed, standing before all of the company's shareholders.
What can also happen is that a company hits a bad patch and misses an interest payment or two but later catches up with these payments and repays the bonds as planned.
As Foster explains: 'On average, it's reckoned that high-yield bonds have a default rate of around 6%, but a fund manager's expertise should enable the worst of these defaults to be avoided. In any case, diversifying a bond fund across a range of different industries and across a variety of maturity dates also ensures that the impact of any such disappointments are minimised.'
Of course, the exact mix in a selected bond fund will be up to the individual investor but they can act to control their personal exposure by mixing and matching differently weighted bond funds within the same Isa wrapper ' so long as they are offered by the same fund manager.
With so many attractive options on offer, it would be more than a shame if this, the last generation of Tessa holders, were to fall victim to the banking sector's carefully orchestrated 'confusion marketing.'
Let us hope that by this time next year, intermediaries will have been able to save their clients from the current accounts now being touted over the counter and found a route for them to enjoy higher returns and better tax efficiency.
l Around £7bn is tied up in Tessas due to mature during rest of 2001.
l Once you remove money from a Toisa it can never be replaced.
l Very few companies fail to meet bond commitments and go into liquidation.
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