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How to get a 10 per cent return

FEATURE: Nigel Bolitho suggests investments and strategies that could help you on your way to a return that's more than ten times what the average cash Isa will pay you
September 26, 2011

High-yielding bond funds

High-yielding bond funds are one of the most popular collective investments for income. They invest in government and company quoted fixed-interest securities and, following the demise of Lehman Brothers and three Icelandic banks in late 2008, were for some time offering double-digit yields – and that's double-digit tax-free interest returns within a stocks-and-shares individual savings account (Isa) wrapper. It's tax-free because Isa managers can claim back 20 per cent tax on interest payments but not 10 per cent tax on share dividends.

Corporate bonds remain popular particularly because interest returns on cash Isas have, if anything, fallen further in 2010. The interest return on a cash Isa can now be less than on the same account outside an Isa wrapper – and that's even after allowing for a 20 per cent tax reclaim.

Various banks also prevent customers from directly switching from poor-performing cash Isas to better earners. For example, Barclays Bank offers interest of just 0.1 per cent on its cash Isa, paid annually in arrears. But an investor cannot switch to Barclays' new Golden Isa issue 2, which offers interest of over 3 per cent, including a 1 per cent bonus for 12 months.

One corporate bond unit trust still offering a double-digit return is Marlborough's High Yield Fixed Interest Fund. It's now available through fund 'supermarkets' such as Fidelity's fundsnetwork at no additional cost. Such platforms allow Isa investors to invest in several different funds managed by different fund managers all in one tax year. Unlike many UK corporate bond funds, Marlborough invests globally, with UK bonds accounting for less than a quarter of funds under management at end-March 2010. Unusually, the fund manager since its launch in November 2004 is Aberdeen Asset Management's Paul Reed. He will continue to manage it even though Aberdeen is about to launch a similar in-house fund for him to manage.

Investors attracted to any sort of unit trust corporate bond fund need to do some homework. Check whether the annual management charge (AMC) is paid out of income or capital. Some funds pay the AMC out of capital to boost income payments but that reduces scope for capital appreciation. The FT is one of the few newspapers that tells you that, printing a C after the fund if the fee is paid from capital, if disclosed. Another point to check is how many credit defaults a corporate bond has suffered.

Most funds, like Marlborough's, hedge currency risk, but a number now include derivatives – or as investment legend Warren Buffett called them back in 2002 "financial weapons of mass destruction". Henderson wants them as an added facility for the Henderson Fixed Interest Fund, while Gartmore's High Yield Corporate Bond is a good example of what can go awfully wrong when using derivatives and before a change of manager. Most – but not all – fund fact sheets give a breakdown of the credit ratings of holdings from AAA to and including BBB for investment-grade bonds and from AA to not listed or junk for non-investment-grade bonds. You can download fund factsheets on the IC website at http://funds.investorschronicle.co.uk.

Not surprisingly, the Marlborough fund does not invest much money in lower-yielding investment-grade bonds, but it's worth remembering that the banks that went belly up in late 2008 were awarded investment grades. Many higher-yielding bonds pay or reinvest interest monthly. Other high-yielding corporate bond candidates include Schroder Monthly High Income, Threadneedle UK High Yield Bond and Investec Monthly High Income.

Enhanced pensions

Unfortunately, most pensions offer poor returns. If you are a reader able to benefit from a defined-benefit (DB) pension scheme (as offered by the Civil Service and a dwindling number of blue-chip companies) you are in luck, because your pension will be based on length of service and final salary. But lesser mortals have to make do with defined-contribution/personal pensions (DC) where annuity returns are bleak.

They are bleak because of the way that a defined-contribution annuity is calculated. The main factors are size of pension 'pot', retirement age and – crucially – prevailing medium-term UK interest rates and longevity. As mentioned previously, UK interest rates are low and, thanks to medical science, people are living longer; indeed, according to the Office of National Statistics, the fastest growing portion of the UK population is the 85-plus-year-olds. In 1983 there were just 600,000 of them, by 2008 there were 1.3m and numbers are expected to double again by 2033.

So how can a person with a personal pension plan get a better annuity return? First of all, your current pension provider or providers probably won't offer you the best annuity returns – so shop around. Unfortunately, only about 20 per cent of pensioners do so. At the same time, try to qualify for an 'enhanced' pension. You should be able to increase the amount of annual pension by 10 per cent or more if, for example, you have diabetes or have had a stroke.

And while there is relatively little competition when selecting an ordinary annuity, there's big competition for enhanced annuities. Apart from Legal & General, the eight life companies usually involved compete avidly for clients. There's a common application form for the potential annuitant to complete (you can download it at www.commonquotation.co.uk) and then it's bid time online. It's also helpful to send in a prescription list with the application form and the more pages of pills and potions regularly taken the better. Early deaths of close relatives are a bonus, too. In fact (and in contrast to life assurance rates) the worse for wear you are the better. That said, you don't want to be too ill as then it may be better to bequeath pensions than cash them in. Once you have taken an annuity (with or without usually 25 per cent tax-free cash) the proceeds become the property of the life company.

And it's possible for employees of companies with DB schemes to be better off taking an enhanced pension. That's if they qualify and the amount of pension (after taking into account escalation) is greater than that payable by the DB scheme. DB schemes are not nearly as generous as they were in paying full ill-health pensions on early retirement. Individuals in this situation need to contact a specialist adviser with appropriate pension qualifications.

But even if you don't think you qualify for an enhanced pension, it's worth checking as there's fierce rivalry amongst the life companies offering such products.

Deferring your state pension

Yes you can defer your state pension and if you do so for any length of time the UK government will pay you weekly compounded interest equivalent to 10.4 per cent a year. And you need do nothing to automatically defer drawing your state pension. And as the pensions section of the DirectGov website says: "if you put off claiming your state pension for at least five weeks you can earn an increase in your state pension of 1 per cent for every five weeks you put off claiming".

You can also take the extra pension earned as a lump sum. Like the state pension, it will be paid gross but is taxable. However the rate of tax charged on the lump sum cannot push you into a higher-rate tax bracket: so lots of potential tax planning there. If you die before taking the lump sum, it can be paid to a surviving spouse or civil partner or form part of your estate. Deferring a state pension should not affect rights to certain state benefits but may not be advisable if a married woman can obtain a bigger state pension based on her husband’s National Insurance contributions record.

Venture capital trusts

Venture capital trusts (VCTs) are a bit of an investment backwater but they are about to come into their own ahead of tax rises in the 22 June Budget. They are quoted limited companies broadly similar to investment trusts. They are best known for offering investors 30 per cent upfront tax relief if money is invested in a portfolio of unquoted securities – and unquoted shares can include those traded on Aim and Plus. The shares have to be held for at least five years; otherwise upfront tax relief is lost unless they are passed to a spouse or civil partner or the investor dies.

But investors seeking 10 per cent income don't want to invest in early-stage unquoted investments – far too risky. Much better to eschew tax relief and five-year lock-ins and buy the shares second-hand after five years. By then, the VCTs will be starting to realise their early investments. The combination of capital returns and dividends can easily produce a 10 per cent-plus annual return. What's more, the VCT pays no corporation tax on gains arising from the disposal of investments and, in the hands of investors, both the capital returns and dividends are tax-free.

The table below shows the double-digit returns mature VCTs can offer. Best to go for general rather than sector-specific funds and a good track record of successful investing and disposals is a must. The table shows what tax-free 'income' returns are currently on offer. Remember they are a combination of income and capital returns and returning capital may erode the asset base. On the other hand, these VCTs are still investing – mainly in follow-up situations – and, like other investment companies, will have written down the value of their investments during the 2007-09 recession. So there's plenty of scope for write-backs and so rising net asset values.

Albion Ventures' portfolio is dominated by bricks and mortar and from a time when there were fewer investment restrictions. The leading holdings include stakes in the Express Holiday Inn at Stansted Airport and the revamped Bear Hotel in Hungerford, Berkshire. Leading holdings at Northern Venture are heavy crane hirer Weldex (International) Offshore and property manager Paladin Group. Northern Aim's list of top 15 investments is headed by Cornish pasty-maker Crantock Bakery and by Aim-traded Asian-based biometric security business RCG. Earlier this year both funds backed a £3m management buyout of Worcestershire-based Lanner Group, acquired from 3i. They also participated in the buyout of Kerridge Commercial Systems, which is another software business based in Hungerford. Two of the largest investments in both Octopus funds are publisher The History Press and Aim-traded plastics products maker Plastics Capital.

There's little or no market for VCTs until they are five years old. But then they become increasingly attractive income vehicles to dodge new Tory taxes.

Venture capital trusts

CompanyShare priceAnnual dividendYield %
Albion Ventures 66.0p 10.0p15.15
Northern Venture67.0p7.5p*11.19
Northern Aim26.5p3.0p11.32
Octopus Eclipse63.5p10.0p15.75
Octopus Eclipse 271.5p7.0p9.79

*On ordinary shares