By ROBERT HARLEY 14/03/2008
Having replaced the old regime of PEPs in 1999, the rules concerning ISAs are being tweaked from April. Firstly the distinction between mini and maxi ISAs will be abolished, with investors able to deposit up to £3600 in a cash ISA and up to £7200 in a stocks and shares ISA, subject to an overall limit of between the two accounts £7200. Secondly existing PEP and Tessa only ISAs (TOISAs) will be reclassified as stocks and shares and cash ISAs respectively. Finally, and less well known, savers will also be able to switch money currently built up in existing cash ISAs to an equity ISAs and this will not count against their annual allowance. This however is a one way street and Investors don’t have the option of moving existing stocks and shares ISAs in to a cash ISAs.
Despite the various tweaks the bottom line remains that since 1999 the overall savings limit of ISAs has increased a paltry £200 from £7000 to £7200, an annual increase since 1999 of less than 0.3%. How then can investors get the most from their annual allowance and given recent market volatility should investors max out their cash ISAs before considering stocks and shares?
With the Bank of England maintaining the base rate at 5.25% there are still a handful of companies offering cash ISAs paying tax free interest above 6%. However for investors seeking an income with the possibility for capital growth then serious consideration should be given to buying a corporate bond fund within their stocks and shares ISA.
What is a corporate bond fund?
Companies, like individuals, borrow money, this is known as corporate debt, and like shares, it can be traded on the secondary market. Importantly corporate debt has a relatively low level of volatility and correlation compared to equities and, as such, should be seen as a key element in any well diversified portfolio.
The recent credit crunch has led to a widening of credit spreads, the difference between the price a company and the Treasury (who has the highest credit rating) pay to borrow money, to all time highs. For example, HBOS recently had to issue corporate debt paying 9.5% interest, which is over 3% higher than their current cash ISA offering.
Investing in a corporate bond fund is not without its pitfalls. The underlying income yields tend to be fixed, consequently their capital values are more volatile than placing money in a cash ISA. However, unlike a cash ISA, a good corporate bond fund may also be able to grow your capital over time, as well as pay a respectable income. ISA yields on the other hand can be variable, moving up or down in step with Bank of England base rates. Currently the consensus view is that UK base rates will fall.
Not only can you invest more in to a corporate bond fund via a stocks and shares ISA than you can in a straight forward cash ISA (£7200 versus £3600 from April 2008) utilising your stocks and shares ISAs in this way has an added tax benefit. Whilst the 10% tax credit was removed from dividends paid in ISAs back in 2004, the income paid by corporate bond funds is counted as interest and, as such, if purchased within an ISA investor can still reclaim the 20% tax credit and receive the interest gross.