Company shares versus bonds

Take Marks & Spencer. It has a bond issue maturing in 2014 with a 5.625 per cent coupon that, priced at 95.15 offers a yield of 6.68 per cent. That represents a huge premium to the savings rate. The average branch-based instant access savings account rate was just 0.17 per cent in February.

The income on M&S shares looks considerably tastier. After steep falls in the past couple of years the dividend yield has now reached 8.5 per cent.

Dividend cuts

A corporate bond is effectively an IOU issued by a company. It must repay the debt when the bond matures as a well as making a yearly fixed interest payment, known as the coupon. There is no such commitment from companies when it comes to their shares.

Alasdair MacLean, investment director at Standard Life Investments, said: "The crucial difference between the two is that dividend payments are dispensable. You have seen companies cut their dividends. If you are investing based on there being a high dividend yield you need to make a call on whether the dividend will be paid."

Unless M&S chief executive Sir Stuart Rose can pull a rabbit out of the hat to beat the recession and maintain the dividend, buying M&S shares for income looks decidedly risky, leaving the bonds looking a safer bet.

The attraction of bonds

M&S isn't the only high street chain with tempting yields on its bonds. Rival clothing retailer Next has a 5.25 per cent issue due to mature in 2013 that, priced at 90.6 offers a compelling return of 7.62 per cent. Next shares have held up better than those of M&S, falling 10 per cent compared with a 41 per cent decline in M&S in the past year. That has left its dividend yield at 4.3 per cent.

The chunky high yields on some retailers' bonds reflect fears the recession will cause consumers to tighten their belts sharply and force companies to default on their interest payments. Yields have risen as bond prices have fallen because fewer investors want to buy them.

Given that a string of retailers have already gone under it is hardly surprising the market is pricing in some risk. For those that would prefer a safer bet, supermarket juggernaut Tesco is an exception. The retail giant has a bond with a 5.5 per cent coupon maturing in 2019 that, priced at 106.54 has a yield of 4.67 per cent. The dividend yield on its shares is a pedestrian 3.68 per cent. The retail giant isstill seen as financially healthy and resilient to a recession. Its returns may be less exciting but they are seen as safer than many of its peers and should not be sniffed at in this record low-interest rate environment.

Away from retailers, BT offers juicy yields on both its dividend and bonds. The former state-owned telecoms group has a jaw-dropping dividend yield of 21.97 per cent after a series of profits warnings sent its share price to record lows. But once again, income investors must remember this yield is historic. Analysts expect the telecoms giant to slash its dividend payout for the first time since 2001. With a large pension fund deficit, it will be mindful of the pensions regulator's warning last month that companies should not cut pension fund contributions if they are still paying a dividend.

So with a big question mark over future dividend payments, investors could consider its bonds instead. One of BT's issues has a coupon of 8 per cent expiring in 2016 that, priced at 108.33 offers an attractive yield of 6.48 per cent.

Within the traditionally defensive sectors, Imperial Tobacco poses a dilemma. Both the cigarette group's debt and shares look relatively attractive. It has a bond maturing in 2012 with a coupon of 6.875 per cent. Priced at 103.48 it is yielding 5.59 per cent. The bond is rated towards the lower end of the investment grade spectrum, reflecting the large sums of debt that Imperial Tobacco took on to buy Spanish rival Altadis. The company's dividend yield is about 3.9 per cent and unusually for this gloomy market, there is the chance of income growth. Analysts at Citigroup have forecast a 16 per cent hike in its dividend payout. That is encouraging given that one of the FTSE's biggest dividend payers HSBC recently cut its payout and even oil giant BP held its dividend. Thankfully, the dividend of Vodafone, another key support to the benchmark's yield, is seen as safe for now and is offering a 5.9 per cent return. Confusingly for investors weighing up debt and equity, it has a bond maturing in 2032 yielding 5.99 per cent.

Higher risks

Turning to the financial sector, an investor needs nerves of steel to tuck into banks' debt or shares.

With growing state control there are fears that banks will not honour the interest payments on their bonds. If they do, the reward is high but so too are the risks. The yields on two of Lloyds TSB’s subordinated bond issues, which rank lower in the pecking order than plain vanilla corporate bonds, were, at the time of writing, 9.7 per cent and 10.2 per cent. But the UK treasury recently made it possible for Bradford & Bingley to defer interest payments on some of its bonds without triggering a default. This sparked fears that other banks effectively under government control might be allowed to do the same and subordinated bond valuations have come down sharply. Liquidity is a big problem.

The banking sector used to be prized for its dividend payments and was a major contributor to income in the stock market. But now they have either been cut or axed.

Dividend cutting is becoming increasingly commonplace. Pub companies Punch Taverns and JD Wetherspoon, bookmaker William Hill and broadcaster ITV have all said they would skip payments. Many more are expected to follow.

Rodger McNair, head of UK equities in Edinburgh for F&C, has predicted a challenging time ahead for investors looking for income in equity markets.

He said: "Given the uncertain outlook for the global economy many companies are now re-evaluating their balance sheet structure. Faced with the need to de-leverage, together with both the difficulty and cost of accessing credit markets some companies are coming to the conclusion that it makes sense to cut dividends in order to maximise cash retention within the business."

Indeed it is increasingly being viewed as prudent to hold back on a dividend payment. If a company is making huge losses, many shareholders would rather it concentrated on fixing its balance sheet and keeping itself afloat rather than making unaffordable shareholder payouts.

Mr McNair said he has been shifting his portfolio away from companies that are heavily reliant on consumer discretionary spend and focusing on those with strong balance sheets, cash flow and visibility of earnings.

With a shrinking pool of obvious equity income candidates, investors have been piling into company debt. A record £1bn was poured into corporate bonds in January. But bonds are by no means risk-free investments.

Assuming a bond is not held until maturity, the capital is at risk because the price will move up and down. Last year corporate bond funds suffered sharp falls as the price of the underlying bonds fell because the risk of defaults went up.

In addition, should the company behind the bond go bust, the interest won't be paid and investors could lose some or all their money.

But Mark Glowrey at fixedincomeinvestor.co.uk pointed out: "Any investment is risky. They [bonds and equities] are two different animals. If you buy the equity, the dividend is certainly not fixed and you are wholly reliant on the future market price of equity."

Doing the research

Information on corporate bonds can be hard to find and the jargon surrounding them can be mind-boggling. Before wading into bonds, investors should take a look at the ratings assigned to them by agencies such as Moody's and Standard & Poor's. They measure the financial strength of the company issuing the bond and its ability to pay the interest and the loan on maturity.