The next high yield treasures

Companies: growth not yield

Carl Stick, manager of the Rathbone Income Fund, reminded us of this truism in the Investors Chronicle a few weeks ago. Buying shares on the basis of historic yield carries one mighty risk – that the dividend is not maintained. Normally, that’s not much of a risk, but in 2008-09 it was an ever-present danger. Banks, miners and even pharmaceuticals stocks cut their payouts.

My stock screen (see checklist and table below) tries to find companies that are steadily increasing their dividends, but which also have low share price volatility and sound balance sheets.

Trusts: something in reserve

When it comes to income, investment trusts have a big advantage over their open-ended cousins: the ability to build up distributable reserves. This has, in some cases (highlighted in the table), facilitated an enviable record of year-on-year dividend increases. Trusts have also benefited from a one-off series of tax back payments after a keenly watched VAT case found in their favour.

Of course, trusts are highly correlated with the equity market, and if there is a severe downturn they will suffer from both falling net asset values (NAV) and widening discounts. Gearing also magnifies downward moves. However, in a rising market, gearing enhances returns and discounts to NAV usually narrow.

Investment trusts

Pibs, prefs and other hybrids

Permanent interest-bearing shares (Pibs) and their cousins, perpetual subordinated bonds (PSBs) have long been popular with private investors owing to their high coupons. Many were issued in the early 1990s when interest rates were much higher, and until 2007-08 they often traded above par.

And then, disaster struck. Bradford & Bingley, by now in state hands, decided to skip its coupon, setting an unwelcome precedent. West Bromwich Building Society converted its Pibs into lower-yielding participation shares. Then, under pressure from the European Commission, Lloyds was forced to restructure its high-yielding debt. Out went the various preference shares paying 9 per cent or more and in came – if you were lucky – ECNs.

So Pibs and prefs aren't what they were; most Pibs now trade at below par. But adventurous types might still be willing to brave this market. Insurance companies RSA, Aviva and General Accident all still have pref stock that pays out more than 7 per cent while the Cooperative Bank has prefs paying out a tad under that. The table below shows some examples.

Venture capital trusts

Many investors consider venture capital trusts (VCTs) to be highly specialised and aimed at sophisticated, high-net-worth individuals. They are tax-efficient structures designed to produce a medium-to-long-term capital gain by investing in small, unlisted, companies in the very early stages of development. VCTs pay out tax-free dividends as part of their capital return for many years, and now VCT manager Downing has taken the idea of that tax-free payout and developed two new structures. Downing Structured Opportunities VCT 1 and Downing Absolute Income VCT 2 are offering an income payout of 5p per £1 invested in the VCT for the duration of the respective fund. Factor in the income tax relief of 30p in the pound and your net effective yield is actually 7.8 per cent. Unusually, the structured opportunities fund uses listed structured products to underpin the payout – half of its proceeds will be so invested, with the remainder invested in target companies.

■ VCTs are at the higher end of the risk spectrum, though, since they are investing in smaller companies.

Covered call funds

Covered call writing is a derivatives-based strategy that allows fund managers to make money from the underlying volatility of shares. To understand how this could work for the ordinary investor, imagine holding a blue-chip share worth 100p. Markets are very volatile and you decide to write away any upside for a period of between three and six months in return for a premium income that could be worth anything between 1p and 10p per share. You'd get this income (plus the underlying dividend cheque) no matter what happened to the shares, but if the shares shot up in value you wouldn't make any of those capital profits – you'd just get your income.

French banks have developed a real specialism in this area, developing a small range of covered call equity funds that produce an income from holding a basket of mainstream equities.

■ Risk – medium. These covered call funds are complicated but if implemented properly can produce decent returns and low volatility especially if markets are volatile. BNP has real experience in this territory and the collateral backing is very strong.

Structured products

The BNP Paribas covered call fund is essentially another form of a structured product. These instruments are controversial, as many experts think structured products force you to sign away too much upside in return for capital protection. However, proponents counter that their funds simply offer another form of absolute or defined return – the equities in the underlying investment generate an income from options that can be used to buy some capital protection and maybe even an income.

There are dozens of structured products available (although some are only marketed through tied advisers), but two particularly interesting ones are issued by Blue Sky Asset Management and Morgan Stanley. The Blue Sky plan is called the High Income Corridor Auto-Call Plan and is a five-year plan based on the FTSE 100 index.

The Morgan Stanley product is the FTSE 100 Accumulated Income Fund 1 and pays every six months a coupon equivalent to 3.37 per cent semi-annually over five years, or 6.85 per cent a year, subject to the FTSE 100 remaining in a 3,200-7,500 range.

■ The main risk with these products is that the market falls (or rises) by enough to either remove your capital protection or your upside exposure. But that looks a sensible trade-off given the range-bound nature of equity markets and the income on offer.

The rehab of RMBS

Residential mortgage-backed securities – yes, they're one of those ever-so-clever structured loans that got us into the credit crunch in the first place. The basic idea is simple. Loan structures backed by mortgages are diced up into lots of little packages and then sold on to institutional investors, spreading the risk of default. Triple-A credit ratings were handed out willy-nilly, and many managers came to regard RMBS as a proxy for cash. We now know, of course, that they aren't.

However, the underlying concept was sound, and with this in mind it may be worth considering TwentyFour's Monument Bond fund. This invests in only the highest-grade structures based on a portfolio of European, UK and Australian underlying mortgages. Its top holding is in the Northern Rock Granite structure (10 per cent of holdings).

All RMBS structures are issued in floating-rate form and TwentyFour suggests that "their coupons will increase along with future base rate rises", protecting them from inflation. The tainted brand name of RBMS has depressed prices; according to TwentyFour, AA-rated RMBS are trading below high-yield corporate bonds.

■ The risk level is relatively low as the underlying mortgages are low-risk, and there's some degree of inflation protection.

Infrastructure funds

The term infrastructure means a great many different things to investors. But the basic concept is the same: a steady stream of reliable income from a service that the public just can't do without. Here in the UK there are three listed infrastructure funds – HSBC's Infrastructure Fund (HICL), International Public Partnership (INPP) and 3i Infrastructure (3IN). Between them they pay out an average income of just over 5 per cent, and invest in everything from UK PFI assets through to a mixture of utility and public partnership assets. In addition to the income there's also the chance of a net asset value uplift as these assets mature or are sold on.

You might also want to have a look at a recently launched fund called GCP Infrastructure Fund which hopes to pay out an income of around 8 per cent a year through holding UK-based private finance initiative (PFI) debt. This fund has a minimum investment of £25,000 and is run by specialist firm Gravis Capital Partners and invests in junior and senior debt and funds projects such as a new NHS Trust mental health facility or primary health care units. Most of the debt structures have some kind of inflation plus formula built into them.

More adventurous investing types might also want to look at an exchange-traded index tracking note traded on the US market called JPMorgan Alerian MLP Index ETNs. These NYSE exchange traded notes – ticker AMJ – track an index that follows the largest Master Limited Partnerships in the US. These tax efficient vehicles are structured like real-estate investment trusts (Reits) and allow any income from holding an infrastructure asset to be paid out gross of tax to investors. The underlying yield of the ETN is around 6.5 per cent a year and the index tracks some of America's biggest gas and energy pipeline infrastructure outfits.

Wealthy Nations Bond

This last idea is a bit of cheat as it still invests in bonds issued either by governments or large corporate entities – it's offered by hedge fund Stratton Street Capital and private bank EFG and accepts investments from £10,000 and up. But this is a bond fund with a difference as it invests in what could reasonably be called 'value' driven bonds with a core global theme that not all emerging market debt is created equal.