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Income from your Isa

Created:

2 March 2010

Updated:

5 March 2010

Written by:

Leonora Walters

With historically low interest rates, the drying up of bank dividends and yield on bonds under fire, finding decent income returning investments is becoming increasingly harder. But income investments held within your individual savings account (Isa) receive an extra boost as this wrapper mitigates tax, and with taxation very likely to rise later this year to address the fiscal deficit, now more than ever before it's crucial to choose the right income funds for your Isa.

Whatever your risk appetite, advisers agree that you should build up an Isa portfolio of different funds offering exposure to different asset classes, although the primary focus is likely to be bonds and equities. "This diversifies risk and can help by giving different payment dates," says Juliet Schooling, head of research at discount broker Chelsea Financial Services.

"Income seeking investors would be well advised to spread their Isa investments this year between corporate bonds, equity income funds and commercial property," adds Martin Bamford, managing director of chartered financial planner Informed Choice. "Opting for a single asset class, regardless of how attractive yields might look, is a high-risk strategy as capital will be at risk."

Bonds remain core

Bonds should form the core of an income portfolio, according to Adrian Lowcock, senior investment adviser at Bestinvest, and while exact allocation will depend on your risk appetite and amount of income required, bonds should account for at least 30 per cent of your Isa portfolio.

"Bond funds often yield more than equity income funds; therefore those requiring a higher level of income may well own a greater proportion of fixed interest," adds Ms Schooling. "Bond funds are also largely lower risk so as an investor ages they may well hold more."

Admittedly, bond funds are not as attractive as they were in late 2008/early 2009 as yields have come down since, however yields are still attractive when compared with cash, and most advisers do not expect rates to rise any time soon.

Other concerns around corporate bonds include the fact that their returns are linked to the UK's national credit rating, which could be cut if steps are not taken to reduce sovereign debt. There are also worries that these funds could see their capital values eroded in an inflationary environment. In response to these threats, Sam Liddle, manager of the CF Miton Global Income Fund, has been reducing UK government bond and sterling corporate bond exposure. He anticipates an increase in inflation, and is finding more attractive equity yields.

In light of these uncertainties, many advisers favour strategic bond funds for bond exposure as they allow the manager to choose how to position the fund depending on the prevailing market conditions. Ms Schooling suggests the L&G Dynamic Bond, M&G Optimal Income or Henderson Strategic Bond fund. These funds also offer some exposure to high-yield bonds which offer attractive returns but also present a higher risk of default - so a fund with a high exposure to these type of holdings might not be appropriate for all investors.

"Strategic bond funds are more volatile and if you are more cautious you should maybe hold one as a complement to corporate bond funds which provide a stable income and stabilised returns, such as the Invesco Perpetual Corporate Bond and Fidelity Moneybuilder Income," says Mr Lowcock.

As for cash, with the base rate stagnant at 0.5 per cent, holding cash alone is unlikely to satisfy income investors. However, Mr Bamford suggests: "Investors could consider short-term fixed rate cash Isa deals for at least part of their allowance, with the balance invested in funds. By fixing their interest rate for no more than a year, they can then take advantage of better rates next year, assuming rates have improved by then."

Another cash account option could be one- or two-year savings bonds offered by banks or buildings societies as these can offer good rates at the end of Isa season.

The return to equities

With bond yields down from their historic highs, there is a particularly strong argument for inclusion of equity income funds in your Isa. "Large, safe companies are paying dividends in excess of the coupons offered by their bonds," says Tom Stevenson, head of corporate and investment writing at Fidelity. "BP shares, for example, yield around 6 per cent, but the yield on its 10-year bond is only about 4.5 per cent.

"This is also the case with shares such as National Grid and Scottish & Southern Energy which offer very attractive dividend yields just now. This is because some sectors had been sold down heavily."

Safer defensive stocks that typically pay dividends were left behind in last year's market rally when cyclical stocks rose, so aside from attractive dividends these stocks also have the potential to rise – especially if they prove popular due to their yields. "We like equity income because it is under valued compared with other income paying sectors," says Mr Lowcock.

Equities in general offer potential for capital growth as their prices can rise and their dividends can be increased. But with many bonds the interest payment is fixed throughout the life of the bond, so their worth is eroded if inflation increases in that time, as is the capital value.

Ms Schooling says that as equities should rise over the long term they should provide a growing income and therefore maintain real income, which also serves as a hedge in an inflationary environment - which is an increasingly possibility in the coming years following government quantitative easing programmes around the world.

Going global

UK equity income funds have provided the mainstay for UK income seekers but with the scrapping of bank dividends - the mainstay of the UK economy - there is an argument that investors should look abroad. But the call to 'go global' goes beyond dividend cuts by some UK equity income funds - many of these funds' top 10 holdings are almost identical to each other due to lack of choice of dividend paying UK stocks. This means that investors holding a range of UK equity income funds are often not getting any portfolio diversification.

For this reason the Miton Income portfolios are increasing their exposure global equities, according to Mr Liddle. He says growth prospects are greater outside the UK and there is a greater choice of companies. His holdings include the Lazard Global Equity Income fund.

"UK investors are often heavily overweight in the UK and, with just six companies accounting for more than 50 per cent of the dividends paid in the UK, diversification is important," says Ms Schooling. "There are a growing number of global, European, US, Asian and even Japan income funds, such as M&G Global Dividend, Newton Asian Income and Jupiter European Income."

Mr Lowcock suggests Ignis Argonaut European Income which currently has the highest yield in the Investment Management Association (IMA) Europe ex-UK sector, at nearly 6 per cent.

For Asian income you could consider Newton Asian Income Fund on a historic yield of 4.8 per cent, or New Star Asian Dividend Income Unit Trust. There are also three Asian income investment trusts: Aberdeen Asian Income, Henderson Far East Income and Schroder Oriental Income.

While geographical diversity is certainly enticing, remember that there is currency risk with overseas dividends, although this can also work in UK investors' favour.

Sticking to home

Historically, the UK has been one of the highest dividend paying markets and despite banks scrapping their dividends last year, it was still one of the highest yielding markets with 3.7 per cent yield, against 3.5 per cent for continental Europe and 3.4 per cent for Asia Pacific ex-Japan region. And the UK is forecast to yield 3.9 per cent in 2010 against 3.7 and 3.6 per cent for continental Europe and Asia Pacific ex-Japan, respectively.

Outside the top 10 fund holdings the portfolios of UK equity income funds are not necessarily the same. Martin Cholwill, fund manager of the Royal London Asset Management Equity Income fund, has looked down the market capitalisation spectrum for alternatives to banks and recently started adding holdings in FTSE 250 general financial companies, Brewin Dolphin and Close Brothers. He has also added to his exposure to Hargreaves Lansdown and IG Bank, as well as South African bank Investec.

"In my opinion, the dividend cuts seen in 2009 denote a rebasing of total UK dividends paid rather than marking the beginning of a trend," says Mr Cholwill. "I believe that this adjustment period is now coming to an end and that, going forward, the stock market will once again be able to distribute a greater proportion of its cash flow as dividends to shareholders."

It is also worth remembering that UK equity income funds can allocate up to 20 per cent of their funds to overseas stocks to diversify concentration. In terms of UK income funds, Mr Lowcock suggests Invesco Perpetual Income managed by Neil Woodford, Artemis Income and Standard Life UK Equity High Income.

Property pays

Commercial property funds are offering attractive yields when compared with cash and equities. However these funds are illiquid (over 2008 and 2009 a number of them suspended investor redemptions), and Mr Bamford says: "It would be unwise to invest too much in commercial property, as this sector remains quite fragile and reliant on the return of strong bank lending. Values have been improving in recent months, yet remain a good 20 per cent down on three years ago.

"But as part of a diversified portfolio, now certainly seems like a good time to increase allocation to this asset class."

Funds favoured by IFAs include the M&G Property Portfolio, New Star UK Property and SWIP Property Trust.

Ultimately, if income is your aim, market conditions mean that you have to look beyond the usual investments. "You have to work harder and be more pro-active, and look to sectors once ignored," says Greg Bennett, manager of the Marlborough UK Equity Income fund. He has invested in real estate companies such as British Land and Land Securities.