If you have been relying on savings for income, the years since the credit crunch have not been easy. The low base rate combined with wider economic problems means most savings accounts have been paying out piddling amounts and, as a result, people have become much more interested in investment income in recent years.
Here, we look at the main income-producing investments, starting with the lowest risk, and examine whether or not they are a good bet.
If you're looking for a slightly better rate than you'd get from a savings account but don't want to take on too much risk, UK government bonds, known as gilts, could be a good start. A government bond is an IOU to a government in exchange for a fi xed rate of interest over a set time.
The amount of interest bonds pay is tied to how risky the loan is considered to be. Historically, government bonds have been regarded as the safest type of bonds because governments are unlikely to be unable to repay the debt when the bond matures; they therefore pay investors a lower rate of interest.
Bond yields - the rate of interest they pay as a proportion of the price paid in the market – go down when bonds are in demand, and 2011's escalating eurozone crisis has driven investors to look for safe havens, pushing UK government bonds and US treasury bond yields to their lowest levels for decades. This means these ‘safe haven' yields are now well below inflation, so investors are losing money in real terms.
On the next step of the ladder is corporate bonds, where you loan money to a business. These pay different rates of interest depending on how secure the issuing company is. But, while riskier, both investment-grade bonds (issued by blue chip firms) and high-yield bonds (issued by less established, riskier companies) are currently a better bet than gilts.
"Many companies are in a better position than their governments," says Andrew Wells, chief investment officer for fixed income at Fidelity. Bond yields are up across the board because investors are worried about macroeconomic problems, so demand has weakened. But the companies themselves are in good shape, making this a great time to buy.
High-yield corporate bonds are riskier than investment grade but Wells believes they can work for longer-term investors. He says the markets are anticipating high default rates for firms issuing high-yield bonds, which are paying generous yields to reflect the risks involved. But these expected default rates "do not reflect company fundamentals", which are pretty robust.
So corporate bonds are one of the most attractive income-generating investments around right now.
STRATEGIC BOND FUNDS
The sensible option for many bond investors is a strategic bond fund that can move between bond classes as circumstances change. A strategic bond fund is particularly attractive as it's not limited by geography or types of bonds: it can hold corporate bonds from UK blue chips alongside government bonds from emerging market economies. The latter are attractive at present as emerging market bonds are expected to deliver impressive growth in coming years.
So what should you buy? Melvyn Bell, investment manager at Lowes Group, suggests M&G's Strategic Corporate Bond fund, run by Richard Woolnough, which yields 4.1%.
The top three highest-yielding strategic bond funds
AXA Framlington Managed Income
Return over three years: 55.78%
Premier Strategic High Income Bond
Return over three years: 24.1%
St James's Place Corporate Bond
Return over three years: 43.65%
UK EQUITY INCOME FUNDS
Equity income funds hold companies that pay regular dividends. Investors in the sector had a great year in 2011. According to Capita Registrar's latest dividend monitor, the amount paid out by UK companies reached its highest level since summer 2008, growing by 16% over the third quarter of 2011. These funds have always been a core holding for people in need of an income; you just need to choose one that best suits your needs.
High-yield equity income funds focus on generating a high target level of income. Adrian Lowcock, senior investment adviser at broker Bestinvest, singles out Schroder's Income Maximiser fund, currently yielding almost 7.5% as one of the best. But, he warns: "In focusing on maximising income, this fund sacrifices much of the potential for capital growth."
If you don't need an immediate high income, you're better off looking for a fund that aims to deliver some capital growth and a rising dividend payout over the years – ideally one that will keep pace with inflation.
Traditionally, the FTSE 100 has been the equity income managers' hunting ground but they are increasingly looking at smaller companies.
"The fact is that 90% of UK companies yielding more than 5% are outside the top 100," says Mark Slater, manager of the multicap MFM Slater fund. Many of these smaller companies have not historically paid much in the way of dividends because they've reinvested the money to expand the company instead. But the best are likely to grow rapidly and become the key dividend payers of the future.
Funds aiming to deliver growing dividends over time include MAM's Acuim UK Multi Cap Income fund, run by Gervais Williams, and Marlborough's Multi Cap Income fund, managed by Giles Hargreave.
The top three highest-yielding UK Equity Income funds
Insight Investments UK Equity Income Booster
Return over three years: 5.22%*
Elite Charteris Premium Income
Return over three years: 4.61%*
EFA OPM Equity High Income
Return over three years: 34.15%
*Three-year return unavailable, one-year return shown
Source: Morningstar, 20 January 2012
GLOBAL EQUITY INCOME FUNDS
The past few years have seen a growing interest in income funds with a global perspective as firms around the world start to focus on paying dividends. Stephen Thornber, manager of the Threadneedle Global Equity Income fund, explains that the beauty of these funds is their flexibility: "We can move away from struggling regions so we've been coming out of Europe in favour of Asia and emerging markets, where we still expect good growth." He also says it's "not too difficult" to find companies in these areas that are paying generous and rising dividends while also enjoying serious capital growth.
Anna Sofat, managing director of Addidi Wealth, recommends the Global Equity Income funds from Lazard or Newton's more targeted Asian Income fund "because they are well-rated funds, paying good levels of income and have the potential for decent equity growth".
The top three highest-yielding global equity income funds
Threadneedle Global Equity Income
Return over three years: 53.25%
Skandia Global Equity Income
Return over three years: 39.86%
Lazard Global Equity Income
Return over three years: 52.87%
It is possible to find income-focused funds that hold both corporate bonds and equities, known as distribution funds. These can work well for income seekers who also want some capital growth.
Distribution funds are not as widely used as they used to be but they are still useful, especially for smaller investors, says Patrick Connolly, spokesperson for AWD Chase de Vere, not least as they are easy to understand. Gavin Haynes, managing director of Whitechurch Securities, recommends the Invesco Perpetual Distribution fund as it is managed by a highly skilled team.
Neil Woodford looks after the equity part of the fund while Paul Read and Paul Causer look after the fixed interest investments. It is paying a yield of 6.5% at present.
The final option for income hunters is structured products. These give some capital protection and a set level of income, provided the index in question doesn't fall below a certain level. Sofat singles out Gilliat's product, paying 6% a year over its six-year term, with capital secure unless the FTSE 100 falls by more than 65% over that time.
"For people who need income, can tie up their capital for that length of time and understand the risks, these products are not a bad deal - but I'd only use them as a small part of a mixed income portfolio," she says. The risk with structured products is they can be complex and there are no guarantees you will get all your money back.
So where are the best places to invest for income? Haynes says recent price falls of equities and corporate bonds mean these sectors are offering great yields. As a result, UK equity income and global equity income funds, plus corporate bonds, look the most desirable.