Searching for income during the storm

The first few months of 2009 saw average savings rates fall to less than 1%, with many accounts paying just 0.01% – literally next to nothing. This is disappointing enough if you were hoping to get a bit of growth out of your nest-egg, but if you were planning to use it to produce a regular income, it’s a catastrophe.

So now may be the time for a serious strategic rethink. There are a few alternatives for income-hunters, but before you start shopping around, the experts all agree your first priority should be to decide the level of risk you’re happy with.

Ashley Clark, a director at, says: “It all boils down to your attitude to risk. If you want no or low risk, the only route you can take is the traditional cash bank account and accept that income levels are going to be low.”

Government gilts

If you’re willing to take on a slightly higher risk, and you need the extra income, the first stop up the jeopardy scale is gilts, which are government bonds. Basically, governments borrow from you, pay a fixed interest rate, and then pay you back on a fixed date. At the moment, gilt funds are yielding just over 3%.

Darius McDermott, managing director at IFA Chelsea Financial Services, suggests the City Financial Strategic Gilt fund, which is yielding around 3.3%.

Gilts involve more risk than cash, firstly because there’s a chance the government won’t be able to pay you back. It’s highly unusual for a government to default on a debt, so they have been considered very safe. But, in the current environment, this risk rises.

McDermott says: “For the first time in a generation people are questioning the record amounts of debt the government has taken on and whether it’s affordable. But, historically, the UK government doesn’t default, so it’s not a big risk.”

The second issue is that not all gilts are bought from the government and held to maturity; some are bought and sold along the way, so there’s a chance for their value, and the value of gilt funds, to rise and fall. They have done well recently, but there’s no guarantee this will continue.

Corporate bonds

If you’re happy to move further up the jeopardy scale, and you’re looking for a higher yield, the next alternative is corporate bonds. These are exactly the same as gilts, except instead of lending money to the government, you’re lending to a company.

McDermott says: “The risk lies in the fact that companies may go bust and the debt may not be repaid. At the moment, of course, defaults are on the increase, so the risk is higher.”

Also, the value of the bonds themselves can rise and fall, and many bond funds have appalling figures to show for the last couple of years as the demand for bonds plummeted. On the other hand, the fact that bonds are riskier at the moment means companies are paying more in order to induce people to buy their debt.

McDermott says: “They are paying 6%-9% to compensate for the risk.”

Mark Dampier, head of research at adviser Hargreaves Lansdown, currently likes the M&G Strategic Corporate Bond, and the Jupiter and Invesco Perpetual Corporate Bond funds. McDermott rates the L&G Dynamic Bond fund, which is up 6% over 12 months, and Adrian Lowcock, a senior investment adviser at IFA Bestinvest, likes Fidelity MoneyBuilder Income.

An increasing number of global bond funds are entering the market. David Leduc, manager of the Newton Global Strategic Bond fund and director of global fixed income at Newton, says: “This enables you to get value from a lot of different markets.”

Equity income funds

If you move yet further up the jeopardy scale, you get to equity income funds. These invest in shares, focusing on the big blue-chip firms that have a track record of good dividend payments. The dividends will be your income.

The big risk is the fact that you are investing in shares. Funds have suffered dismal falls in the last 12 months or so. Dampier warns: “Over the next year at least, the sector will fluctuate like hell.” For this reason, he says, equity investment requires at least a 10-year view.

A further concern is that companies are currently struggling and, in some cases, cutting dividends. Funds will focus on those firms they believe have cash in the bank to keep paying dividends, but there are no guarantees.

In return for taking these risks, there is potential for both income and growth. Income is particularly strong at the moment, because share prices have fallen so far, and equity income funds are offering average yields of around 6%. Dampier rates the Artemis and Invesco Perpetual Income funds.

David Holloway, marketing manager at Rathbone Investment Management, adds that the aim of his funds, and those within this sector, is to “provide a stable income that grows over time”.

This means income has the potential to rise in the future too. Gavin Haynes, managing director of adviser Whitechurch Securities, says: “This is key to the philosophy of investing in equity income.”

Global equity income funds

Go further up the jeopardy scale again and you’ll find global equity income funds. These are similar to UK funds, except there are only a handful of big blue chips that pay reliable dividends in the UK, whereas global diversification offers a huge range of companies to choose from.

James Harries, Global Higher Income fund manager at Newton, argues that most UK investors have too much of their investment concentrated in sterling-based assets; a global fund would provide useful diversification. However, investing in other currencies brings an added level of risk, unless the fund hedges the currency.

In this sector, McDermott likes the Newton Global Higher Income fund, which is generating around 6% at the moment, and Ignis Argonaut European Income fund.

Equity income investment trusts

Further up the scale again are equity income investment trusts. These are very similar to other equity income investments, but they are structured differently from the unit trusts and open-ended investment companies that make up the bulk of the market.

Unit trusts are open-ended, which means there’s no cap on how much money the fund can take, so the price depends purely on the value of the assets it holds. Investment trusts, on the other hand, are closed-ended. They are structured as companies with a limited number of shares.

The share price of the fund moves up and down depending on the level of demand, so the price of the trust depends not only on the value of the underlying investments but also on the popularity of the trust itself. In difficult times, when investors are selling up, trusts are likely to see their share price fall more than the value of their underlying investments.

Of course, this also means that on the flip side they have more potential for greater returns once better times resume. At the moment, growth and income trusts are popular with investors; they tend to yield around 6%.

Distribution funds

Outside of the basic asset types there are a number of products designed to produce an income. This includes distribution funds, which sit somewhere between bonds and equities on the jeopardy scale. Clark says: “These are managed funds, investing in a combination of bonds, equities and commercial property in order to produce an income.”

Haynes is bullish on the case for distribution funds: “Typically, investment is split between dividend-producing equities and corporate bonds, both of which are favoured areas right now.”

He rates the Investec Managed Distribution and Invesco Perpetual Distribution funds, and says you can expect yields of around 5% from this sort of fund.

Structured products

It may also be worth looking at structured products. On the surface, these work fairly simply: they promise a certain income and your money back at the end of the investment period, as long as whatever index the fund is linked to doesn’t fall below a specified level.

So, for example, the Barclays Regular Income Bond will pay 7.5% a year, and will provide your money back at the end of the period, as long as the market doesn’t fall more than 50%.

Below the apparent simplicity, however, they use very complex products like derivatives, as well as a third party to provide the guarantee, which involves a few risks. The first is that the guarantee is only as safe as the institution promising it. The second is that index performance may breach the barrier, so your money may shrink if the market does worse than expected.

Opinion is divided on structured products. Clark says he wouldn’t recommend them, but agrees there is a place in the market for them, as they provide high regular income.

There are several on the market at the moment, including the Premier Limited Edition Number 42, which offers 8% per year fixed income for five years, with your money back, as long as the index isn’t down 50% on the last day of the period.

These structured products have the advantage of producing a fixed income. For other funds, one compromise you have to make is to accept that the amount you receive in any given payout is going to fluctuate depending on how the investments are doing.

In addition, only a relatively small number pay every month. Most will pay quarterly or every six months.

Build a portfolio

One solution is to build a portfolio of income-producing funds. This will hopefully ensure that your total income is less affected if some funds cut payouts. Haynes adds: “The volatility shown by most asset classes and markets means it remains prudent to retain a percentage of your money in cash, to protect part of your money in the short term.”

However, before you start building your portfolio, there’s one final consideration. Buying into these products isn’t a quick fix. The rates on cash may recover in the next few years if we go into a period of inflation, but you shouldn’t just switch out of these alternative investments on a whim.

You need to be committed for however long is right for the product: bonds for five years at the very least; equities for five to 10 years; and structured products for however long they last.

Of course, in that period you may have seen some capital growth as well as better income, and in some instances investors may decide there is a place for a little extra risk in their portfolio, for the long run too.

But it pays to consider how you would feel if interest rates returned to where they were a couple of years ago and you were tied into something else for the long term.

The death of a traditional option

Guaranteed income bonds used to be a fixture of this market. These bonds are offered by insurance companies, and pay a fixed income over a certain period.

Gavin Haynes explains: “In effect, they’re usually an investment into the gilt market using the tax advantage of the life insurance company.”

One risk is that the insurer itself goes under, but you would be able to claim 100% compensation on the first £2,000, and 90% of the rest of the investment. There are also products run by NS&I which have the government to fall back on for guarantees.

However, GIBs have some serious flaws. They pay income after basic rate tax, which is a problem for non-taxpayers. In addition, it’s not just income that these products pay out. The risk is that if the investment doesn’t perform as intended, it may eat into some of the capital in order to pay the guaranteed rate of income.

But the main problem with these products at the moment is that they’re not offering that much income. Over one year you would struggle to get 1% on £5,000, over two years you’d get just over 1%, and over five years you’d be looking at less than 2.5%.

Haynes says: “It’s hard to find very attractive rates right now; we wouldn’t recommend any issues at present.”