Three ways to extract income

The lower-risk bundle: 0.3 to 4 per cent

Government bonds or gilts dominate the low-yield, low-risk end of the spectrum.

The simplest way of buying into gilts is to buy directly, either through the Post Office or via your stockbroker. If you want to buy a pooled collection of gilts with varying term dates and structures, you can either invest in an actively managed gilts fund or an index-tracking fund. In the actively managed space respected fund managers include Allianz Pimco, M&G and Fidelity – to take just one example, the Jim Leaviss' managed M&G Gilts and Fixed Interest fund (AA-rated by Standard & Poor's) yields 2.89 per cent with a management charge of 0.75 per cent a year.

You can also buy index-tracking funds in the gilts space. iShares now dominates this space and provides a range of index-tracking funds that produce an income from investing in gilts (and foreign government bonds as well). The dominant fund is called the FTSE All Stocks Gilt fund (ticker: IGLT) which invests in the full maturity range of gilts in a structure that costs 0.2 per cent a year and currently produces a running or flat yield of 4.29 per cent and a yield to redemption of 2.89 per cent. iShares also offers a variant on this structure, namely one that focuses exclusively on nought to five-year maturity gilts (IGLS) and is producing a yield to maturity of 1.49 per cent a year.

Investors worried about inflation in the future can use index-linked government bonds – these increase their coupon in line with inflation. If inflation goes up, the yield or coupon increases. The government issues debt in this form via two routes – the first through National Savings & Investments via its Index Linked Certificates (NSandI.com), as well via index-linked gilts issued to big institutions. NS&I index linked certificates are linked to RPI with three- and five-year certificates currently paying out the princely sum of Retail Price Index (RPI) plus 1 per cent tax free. Index-linked gilts can also be purchased directly, through an actively managed fund (the M&G Index linked fund, for example, is yielding 1.17 per cent) or again through iShares via its Index Linked tracker fund, INXG, yielding 0.99 per cent at flat yield and 0.49 per cent to redemption.

Money market funds are also fairly low risk. In the unit trust world there are dozens of well established money market funds that invest in anything from straight cash through to gilts and wholesale money market instruments. The vast majority pay less than 1 per cent a year, with market leaders such as Fidelity and F&C paying between 0.18 per cent and 0.5 per cent.

With rates this low, high-street savings accounts look increasingly attractive. They are all covered by government compensation limits. But watch out for short-term promotions, access terms and payment frequency of interest. Top-ranking fixed-rate savings bonds for a year are paying around 3.75 per cent for a year while five-year bonds can pay as much as 5.5 per cent (Barclays and Yorkshire). According to www.moneyfacts.co.uk, high-yielding cash Isas are paying between 2.5 and 3 per cent a year while easy access savings accounts pay between 2 and 3 per cent.

Wealthier investors looking for a more consistent rate might be tempted by Investec Bank's High 5 Account which pays the average of the top-five MoneyFacts-rated accounts. It's only open for those with more than £25,000 to invest, and it's paying 3.35 per cent a year in interest (http://www.investechigh5.co.uk/).

Moving up the risk spectrum, there are guaranteed income bonds offered by the big insurance companies, for terms varying between one and five years. These are relatively safe as they're covered by government compensation schemes – if the insurer were to go bust, you can claim compensation of up to 90 per cent of the sum lost. Rates for one year currently tend to be between 0.2 and 0.6 per cent while five-year rates stretch to between 2 and 3 per cent.

The medium risk bundle: 3.5 to 7 per cent

Corporate bond funds have become a popular choice for private investors seeking a higher, more diversified rate of return. These funds invest in a range of corporate debts ranging from lowest-risk investment-grade bond funds through to high-yielding funds where the average debt rating is BBB or less. The huge choice of open ended funds in this space can be confusing – although familiar names such as M&G, Fidelity, Threadneedle and GLG tend to predominate – and investors will be tempted to go for the highest yielding.

Many very high-yield bond funds – run by respected names including Investec, New Star, and L&G – are yielding more than 7 per cent a year while most mainstream funds yield between 4.5 and 6 per cent. That difference in headline yield is hugely important as these funds tend to be loaded up on higher-yielding debt, which carries higher risk of default and therefore capital loss.

iShares also offers its own index-tracking ETF corporate bond fund (the sterling version is called SLXX and tracks the iBoxx Sterling Liquid Corporate Long-Dated Bond Index). This is a blended fund that offers exposure to both investment and sub-investment grade corporate bonds (top holdings include Barclays, Imperial Tobacco and GlaxoSmithKline) with a yield of just under 6 per cent. Investors worried that over 50 per cent of the fund is invested in A or lower-rated bonds could consider the non-bank version of the fund which yields closer to 5.5 per cent.

Investors can also invest directly in corporate bonds – Mark Glowrey picks a new corporate bond every week in Investors Chronicle. Most reputable bonds he highlights tend to be in a 4.5 to 6 per cent range with a few high-yielding real-estate investment trust (Reit)-based bonds yielding closer to 8 per cent.

RBS has launched a certificate called the Royal Bond that pays out 5.3 per cent a year for the next six years on an annual basis. This is in effect a corporate bond issued by RBS – if RBS goes bust, your payment could be jeopardised and it's not covered by any government savings guarantee but you can buy and sell the product whenever you like via a stockbroker.

The Nationwide Building Society is offering Pibs. These hybrid debt structures (look for ticker POB, POBA and NANW) pay between 7 and 7.5 per cent a year. It's worth remembering that Pibs can be tricky to trade with some large spreads opening up as volume levels dry up. Investors might also want to consider Britania Building Society's old Pibs, now trading as Co-op stock CPBB – these yield 7.6 per cent net of tax.

Some countries also pay out a much higher coupon on their government debt – emerging markets in particular are a source of extra returns with their governments usually forced to pay out anything between 200 and 1,000 basis points more in yield for their riskier debts. One of the most interesting newest entrants to this market is Stratton Street Capital/EFG Private Bank's Wealthy Nations Bond fund which only invests in sovereign debt from countries with low overall debt levels.

Countries such as the UAE and Qatar may sound unappealing on first inspection, but these countries boast very low levels of government, personal and corporate debt and high credit ratings with no history of past defaults. Using a research process that pegs fund holdings to a macro-economic analysis, the fund is able to run with a redemption yield of 8 per cent a year in dollar terms. By comparison, the iShares Emerging Markets debt fund (IEMB tracking the JPMorgan Emerging Markets Bond index) is yielding 6 per cent (redemption yield to maturity) and is heavily invested in countries such as Turkey, Philippines and Venezuela. By comparison, most top-rated global bond fund managers such as GLG and M&G are struggling to get anywhere near 5 per cent a year for their more targeted emerging markets and mixed sovereign debt funds.

The potential of greater capital gains and a decent income help explain why the UK's top equity income fund managers have taken in so much money over the past few decades. Managers such as Neil Woodford at Invesco Perpetual now sit on billions in funds under management, producing a yield that varies between 4 and 4.5 per cent depending on the fund.

Highly-rated competitors include Rathbone (Blue Chip Income and Growth, yielding 4.5 per cent) Neptune Income (4.4 per cent) and Trojan Income (4.14 per cent) while Jupiter and Threadneedle both run an array of equity income funds that also invest in fixed-income securities and produce yields of between 5 and 7 per cent a year. Nearly all of these funds tend to invest in a relatively small group of large blue-chip UK companies with a history of progressively increasing their dividend payment over time.

There's no equivalent to these equity income funds in the index-tracking world – the nearest is iShares' UK Dividend Plus index fund (IUKD) which tracks the highest-yielding stocks in the FTSE 350. It's been a terrible investment over the past few years but is paying out a yield of 5.28 per cent through holdings in companies such as Scottish & Southern, United Utilities, Provident Financial, RSA and Severn Trent.

For sophisticated investors there is a small number of infrastructure funds listed on the London market. HSBC Infrastructure Company, International Public Partnerships (INPP) and 3i Infrastructure all invest in a range of mainly UK but also developed world infrastructure and PFI projects. These closed-end funds are not without risk – they trade on the market and are therefore volatile and invest in assets that could be affected by government regulation – but the underlying assets are pretty safe with dependable cash flows. The yield for these three funds varies between 5 and 5.5 per cent a year.

The higher-risk bundle: 7 to 12 per cent

The traditional tax treatment of investment trusts has discouraged too overt a focus on income as a primary driver of total returns, but there are some collective funds that can produce a diversified income flow of well over 7 per cent a year.

Numis has identified a number of potentially interesting funds paying out a big dividend from a combination of corporate debt and high-yielding equities. "Within the investment trust sector, there are relatively few corporate bond funds and these tend to be higher risk vehicles, with a significant weighting in non-investment grade debt, notably Invesco Leveraged High Yield, City Merchants High Yield, New CityHigh Yield and Henderson Diversified Income. There are also a few investment companies that have a mandate to invest in both equities and bonds, including Investors Capital, Henderson High Income and some of the split capital funds."

Numis also identified the Reit sector as a source of potential income. Both they and Winterflood are particular fans of two ING vehicles: ING UK Real Estate (15 per cent discount, 9.2 per cent yield) which according to Numis currently stands out in terms of relative value, and its dividend is fully covered. Numis also identifies another alternative as ING Global Real Estate Securities (21 per cent discount, 4.7 per cent yield) – which has a covered dividend after the board reduced its payout to a sustainable level in the first quarter of 2009. This fund invests in property companies on a global basis, with around 80 per cent in listed securities.

French banking group BNP Paribas also boasts a number of interesting investment trusts with an explicit high-income yield strategy – its UK High Income fund and UK Enhanced Income fund. The first fund was launched in 2006 while the latter fund hit the UK market only a few weeks ago, but both share the same underlying investment idea. The fund managers identify a basket of high-yielding large-cap stocks and then sell away any right to the increase in the share price for a period varying between one day (the UK Enhanced Income fund) and three months (the UK High Income fund).

Imagine ACME plc with shares at 100p. The fund holds these share but writes what's called a call option that says that any gain over the next six months above 102.5p goes straight to the option buyer. This effectively caps any capital growth for those six months at 2.5p, but the writing of the option generates a handy income – both funds were set up to pay out the equivalent of 8p in the pound in income, both which is generated from the underlying dividends and options writing. The UK High Income fund has fallen in price to around 67p and is generating a yield of over 12 per cent, although you need to understand that any capital uplift in these shares is likely to be fairly limited as the options are written away for six months – the UK Enhanced Income uses a daily call writing strategy and has greater potential for capital uplift.

Structured product provider BarCap operates a similar strategy with something called its Water Fund – trading at around 82p, it's currently yielding close to 12 per cent from a basket of global water companies. With all these covered call funds, investors need to understand that they risk further downside if shares fall, but that their upside capital participation might be limited if shares carry on rallying.

Structured products providers such as BarCap and Merrill Lynch BoA offer a much wider array of products that can spice up your yield – one example is the BarCap Six Year FTSE 100 8.25 per cent Protected Income Note, which is currently producing a headline rate of just above 8 per cent a year. Merrill Lynch – through a fund called Merrill Lynch Income 4 (31C) – and French structured-product provider SocGen provide similar vehicles producing between 7.5 and 8.5 per cent a year with the same structure, which usually consists of a quarterly or twice yearly coupon payout based on the idea that the FTSE 100 will not breach a 'barrier' – usually between 2000 and 3500.

If that barrier is breached the coupon will be hit and the capital value of the note will also fall. BarCap also offers a slightly more unusual variant on this theme: its six-year FTSE Participation & Income note offers investors a reduced 5.5 per cent income payout but in return gives 50 per cent participation in the upside of the FTSE 100 – this is fairly unique in producing an enhanced income and some potential for capital gain. Merrill also has a fascinating small fund called the Merrill Lynch 7 per cent Fixed Income (24B), which pays out an income close to 10 per cent a year and offers 1:1 tracking for the FTSE 100 through to 2013, but with one crucial limit: it'll only ever pay out the maximum 100p a share if the FTSE 100 hits 6110. Any increase in the FTSE above that level will still only give investors 100p, but with the shares trading at around 72p, there's still potential for a near 50 per cent capital increase (if the FTSE increases) and a substantial income stream.