Playing the investing for income game

For anyone looking to generate a decent level of income from their investments, these are challenging times, with rock-bottom interest rates meaning the returns on offer from banks and building societies typically fail to keep up with inflation.

So the big question is what savings and investment products are available that will produce the level of income you need - whether that's for immediate use as a supplement to your salary or pension for holidays and luxuries, or to reinvest and boost the value of your investment portfolio with the longer term in mind.


Your first port of call should be cash. Banks and building societies are offering very low interest rates but it's still worth holding some money in a cash ISA (up to £5,640 is allowed in the 2012/13 tax year), because even though returns will be low, they will be free of income and capital gains tax.

The alternative is to use a taxable savings account. Again, these are not paying much, and you will be taxed on interest earned, making it even harder to generate an inflation-beating income - particularly for higher-rate taxpayers. However, most people like to hold some cash to meet unexpected expenses.

Fixed interest

A popular source of income is a bond. With these, you are effectively lending money to the issuer in exchange for a fixed rate of interest over a set period, with your original investment returned on a specified future date.

Although they can theoretically be issued by anyone, the most commonly used bonds are those offered by national governments - known as gilts when they're issued by the UK government - and public companies when they are attempting to raise money.

These investments can provide a strong degree of capital security and pay a steady income to investors. It's also possible to obtain relatively high levels of income if you tap into high-yield bonds or some overseas fixed-interest holdings. However, there's absolutely no guarantee your investment will be repaid in full, as the company issuing the bond may end up going bust or encounter problems in meeting its interest payments.

To help you form a judgement about a company's prospects, specialist credit agencies such as Standard & Poor's look at each one and award a rating based on their assessment of its ability to pay back the sum borrowed.

The most trusted are given a triple A (written as AAA) ranking, then it goes down on a sliding scale through AA, A and BBB. Anything rated BBB or above is classed as investment grade; bonds with a rating below BBB are known as high yield or junk bonds. Typically, however, private investors access bond markets through a bond fund, rather than individual bond holdings.

Investing in shares

You can also generate an income by buying shares in companies that pay dividends to their investors. As dividends are distributed as a fixed amount per share, shareholders receive a dividend in proportion to the size of their shareholding. The payment of a dividend can be viewed as a statement of confidence by the management team about the future prospects of the business. High-quality dividend-paying companies are also likely to deliver capital growth over time.

It can be tempting to buy companies that have the highest yield - defined as the dividend paid expressed as a percentage of the company's share price - especially as a number of companies are yielding more than 5% at the moment.

However, this can be dangerous as it may mean the share price has fallen because the company is in trouble, or that it's paying a high dividend that it cannot sustain. You will have to look at the company in more detail in order to get a clearer picture. Also, examine the dividend payment history to see what it has paid out to investors in the past.

Companies perceived to be the most likely to pay and increase dividends over the years are those with decent levels of free cash flow - which is effectively the amount of money they have at their disposal after paying all the various costs associated with their business activities.

In many cases these will be the big so-called blue-chip corporate giants that have traditionally operated in areas such as tobacco, oil and pharmaceuticals. However, it is increasingly possible to enjoy healthy dividends from smaller companies. It all comes down to research.

However, there are big risks attached to investing in individual shares. Apart from the costs involved, you need a substantial amount of money to be able to buy enough shares to achieve much diversification, and you then need the time to monitor them. Pinning all your hopes on a handful of shares also leaves you vulnerable to any problems those companies may encounter.

Income-generating funds

A safer, cheaper alternative to individual shares or bonds is an investment fund - either a unit trust/open ended investment company (OEIC) or an investment trust. For most people, a fund is the most sensible option, as the managers will be making key decisions based on their knowledge and expertise, and monitoring them regularly.

For unit trusts and OEICs, equity income investors should look primarily at the IMA UK Equity Income and Global Equity Income sectors. It can, of course, be tempting to stick with funds focused on UK companies but this may end up being rather short-sighted as you'll be overlooking potentially attractive sources of income from around the world.

Moreover, a criticism levelled at many established larger UK Equity Income funds over the past few years has been their reliance on a relative handful of companies and sectors with a longstanding record of paying substantial dividends, including financials and utilities. But a number of these areas came badly unstuck during the global credit crunch - especially banks, which struggled and in many cases suspended dividend payments. Other prominent dividend payers, such as oil giant BP, have also suffered problems that have affected the levels of income being paid to shareholders.

Buying into equity income funds means the manager makes all buying and selling decisions in order to generate an income; you can either receive payouts or have them reinvested for better longer-term gains.

You can also opt for a fixed-interest fund holding a portfolio of bonds. Depending on how much risk you're prepared to take and how much flexibility you want the manager to have, you could look at the IMA Sterling Corporate Bond, Strategic Bond, High Yield Bond or Global Bond sectors.

Investment trusts are structured rather differently from unit trusts. They are quoted companies in which you buy shares. The price of the shares is determined by supply and demand, rather than the value of the underlying assets in the trust portfolio. This "double-layered" structure means the value of an investment trust may be more volatile than that of a comparable unit trust (which directly reflects the value of the underlying investments). However, investment trust charges are usually lower.

One advantage with investment trusts is that they can retain up to 15% of the income they receive each year and put it into their reserves to pay out in more difficult years when companies may struggle to maintain dividend payments. This process is known as "smoothing", and can mean a more consistent income for trust investors.