Issues surrounding income crystallise to three basic questions. First, whether to go for modest but growing income, or a higher but static yield. Second, whether to choose yields that are eye-catching, but come with some risk to income or capital, or to plump for lower but dependable payouts. Finally, what percentage should you invest in individual bonds or shares, and how much in funds?
For the first question, most independent financial advisers (IFAs) would choose growth over yield. "If you want your income to grow, you have to go for equity income," said Ben Yearsley of IFA Hargreaves Lansdown. "However, a natural yield above 5 per cent is fairly rare in equity income funds," he added.
To illustrate the power of income growth, it is hard to beat Invesco Perpetual High Income, which has turned £10,000 into £24,560 with all income reinvested over the past 10 years, and with a total expense ratio (TER) of 1.68 per cent. The benchmark UK equity fund would have turned £10,000 into £14,000. Yet the yield on star manager Neil Woodford's fund is just a shade under 4 per cent.
There are other ways to look at income, though. "Law Debenture is one we like, offering a yield of 4.4 per cent," said Mick Gilligan at Killik & Co. It is an investment trust that looks at equity income and also has a big trustee business attached to it, with a TER of just 0.5 per cent. "The net asset value (NAV) doesn't take account of the income generated by the trustee business," he added.
Bond funds
"We like Henderson Diversified Income, too," said Mr Gilligan. "Half the portfolio is in loans, which means they are secured over company assets." This bond fund trades on a 9 per cent discount to NAV and is currently yielding 6 per cent. The TER is 2.25 per cent and there is a performance fee.
Going for higher returns inevitably brings investors in touch with lower-quality assets. Indeed, many bond funds, such as the newly launched Alliance Trust Monthly Income, have the ability to take holdings in sub-investment-class debt up to a certain level, so you don't necessarily avoid junk completely even if you don't go for a conventional corporate bond fund.
There's not much in equity income to touch the 8 per cent gross yield to redemption of the Royal London Sterling Extra Yield fund, or even its 7 per cent running yield. "However, there's a lot of non-rated and sub-investment-grade in there," Mr Yearsley noted. The fund has a TER of 1.38 per cent.
"Bond funds are cheaper and always have been," Mr Yearsley said, although he believes that costs should play second fiddle to performance. Investors could also consider hybrid funds, which include both bonds and shares, but do tend to have high fees. Some, such as Invesco Perpetual's Distribution fund, however, have a reasonable TER of 1.56 per cent. The Invesco fund has returned over 35 per cent since the corporate bond market's lows of November 2008.
Junk for a while
In any case, steering entirely clear of junk may be a mistake. Sure, some bonds are born junk. But some achieve junk status and some have junk status thrust upon them, to paraphrase Shakespeare's Twelfth night. General Motors falls into that second category, and accident-prone BP narrowly avoided the third. For two weeks in June, the price of credit default swaps for insuring BP debt against default were signalling that Britain's biggest oil firm was indeed junk. Yet those who bought BP bonds as junk then may now be holding investment-grade gold.
The company's 4 per cent bond due December 2014 has already pulled back six points from its low of 90, although it has a long way to go before it returns to pre-spill levels of 105. Besides, junk isn't as dangerous as many believe. By the third quarter of 2010, Moody's reckons default rates will have fallen to 3.3 per cent.
Those with an adventurous streak can look at Neuberger Berman's Distressed Debt Investment. This London-listed fund launched in June having raised $200m, and holds senior asset-backed loans in distressed American debt.
Gravis Capital Partners is launching a closed-end fund to target private finance initiative (PFI) bonds, with an initial yield of 8 per cent. That's good, but a flow of suitable new securities would be subject to the highly political development of the PFI market.
The joy of junk
Junk bonds are those of less than investment-grade (Baa3 for Moody's or BBB for Standard & Poor's) in which the investor is faced with a higher-than-usual yield in exchange for a higher-than-usual chance of default. Although junk bonds came to fame in the 1980s when leveraged buyouts and the activities of Drexel Burnham Lambert and Michael Milken became notorious, they have been around since the early part of the last century. The first mutual funds specialising in junk were set up in the 1970s.
The debate about whether junk bonds are a good investment has raged since the 1920s, but according to a study by Kevin Maloney, Richard Rogalski and Lakshmi Shyam-Sunder in 1992, once lack of liquidity, risk of total loss and the chances of missed payments are all factored in, it seems the market has done a broadly accurate job of assessing their worth.
The big advantage to having junk as part of a portfolio is that these securities do not correlate strongly with investment-grade or government bonds. The interest rate effect on such bonds is muted, compared with the vital ongoing assessment of the creditworthiness of the borrower. By being more specific to a borrowers’ situation, risk in a portfolio of junk bonds is geared to the state of the corporate economy as a whole. In that sense, they are closer to equities in their risk sensitivity. Likewise, good stock-pickers who are happy to number-crunch balance sheets can expect to do better getting returns with junk bonds than with investment-grade bonds, by avoiding the issues that are likely to default.
Finally, shareholders who dismiss junk as too risky have to be aware that any kind of debt will be paid off before shareholders if the company goes bankrupt. Junk bonds actually aren't that risky, either. The percentage of junk bonds that defaulted in the current economic downturn peaked at 13 per cent in 2009 – three times the rate of the previous year according to ratings agency Moody's, but still lower than the Great Depression's peak rate of 15 per cent.
There are two aspects to note. One, default does not necessarily mean total loss. In 2009, Moody's calculates that investors recovered 48.6 per cent of their money in defaults, if one includes so-called 'distressed exchanges'. This is the process where a struggling debtor avoids default by tendering for existing debt (or offers to exchange for new securities) on terms which lead to losses for holders. Obviously, including distressed exchanges increases the total of defaults, but also raises the recovery rate. Excluding such exchanges, the 2009 recovery rate would have been far lower at 21 per cent.
Second, fund investors should beware of seeing default as the only chance of loss. Fund managers dump bonds that they think are destined for default long before that happens. So while a fund may boast few defaults amongst its stable of bonds, the capital losses from impending default are still in there.
Bonds, funds and tax
If you want your income tax-free, individual savings accounts (Isas) and self-invested personal pensions (Sipps) are the way to go. Investments that pay gross include most individual bonds, and are Isa-able as long as they are not convertible or have under five years before a call date. Preference shares, by contrast, although they may have a high yield, are paid net of basic-rate tax.
One thing to watch out for in exchange-traded funds (ETFs) is that many of them are subject to income tax because of their offshore nature. This arises where they do not have 'distributor' or 'reporting' status, something that you may have to check in the small print. Clearly a 50 per cent taxpayer would be miffed to have to declare income on a fund bought for its superior yield, rather defeating the point. Those that do have distributor or reporting status are instead liable for the more manageable capital gains tax.
You have to watch overseas-based funds in any case. US-based funds have a 30 per cent withholding tax, halved for those who fill out a W-8BEN form, while those in France are subject to 25 per cent. Only 15 per cent can be credited against UK income tax liabilities. Most bond funds are open-ended, to avoid an internal taxation liability that arises through UK-domiciled investment trusts (ITS). Some ITs are based in the Channel Islands or elsewhere to avoid this tax disadvantage.
A cheap way in
ETFs are a great and cheap way of accessing high yields. Most of the UK-listed products are from iShares, ranging from the FTSE UK Dividend plus, yielding 4.3 per cent, through to the iShares JP Morgan Emerging Market Bond fund, which yields 6.38 per cent and holds sovereign and big company debt.
Given the withholding tax disadvantages of US-based income sources, the only reason to cross the pond is for exceptional income yields. Take the iBOXX High Yield Bond Fund from iShares. This has an 8.8 per cent distribution yield, and a large spread of junk holdings across utilities, infrastructure and healthcare, with no holding exceeding 1.1 per cent of the fund. Started in April 2007, it would be no surprise that total performance has been dull, but this is surely a good way to get exposure to economic recovery, with a TER of just 0.2 per cent. Alongside it, with similar performances, are the SPDR Barclays Capital High Yield Bond ETF with a yield of 12.4 per cent, and the PowerShares High Yield Corporate Bond Fund, which yields 8 per cent.
Big returns in bank debt
Small investors are now looking more closely at individual bonds, including the but also subordinated bonds in some of the big banks.
One worth looking at is the HSBC Capital Funding Lp 8.208%. The bond is rated A- by S&P and A3 by Moody's, and is callable on 30 June 2015. With less than the crucial five years to run it is too short for an Isa, but can still go into a Sipp, where its gross yield of 7.7 per cent will be protected. The yield to call is 6.6 per cent at a price of 106.5. "A prime attraction is that if not called the coupon reverts to the five-year gilt yield plus 465 basis points," said Patrick Gordon, senior investment strategist at Killik & Co. He said this could be particularly attractive if as expected gilt yields rise sharply by the call date.
In a similar vein is the Standard Chartered 8.103% callable on 20 May 2016. This is an Isa-able issue, rated BBB+ by S&P and BA1 by Moody's. At a price of 106.5, the income yield is 7.6 per cent and the yield to call 6.7 per cent.
The coupon reversion if not called is five-year gilts plus 427.5 basis points.
"A lot of the banks look a lot healthier now than during the financial crisis," Mr Gordon says. However, if you want to steer clear of banks, there is a very solid issue in the Imperial Tobacco 6.25 per cent subordinated bond due 4 December 2018. Just investment-grade, it is rated BBB by S&P and Baa3 by Moody’s. The income yield is 5.7 per cent, but because it is trading above par at 110.5, the yield to call is 4.7 per cent.
