Funds offer many ways to generate income and are becoming more popular as income seekers struggle to raise income from their savings. Stockbrokers and fund supermarkets report that clients are converting cash individual savings accounts (Isas) into stocks and shares Isa funds to generate a higher income.
Corporate bond funds
The most obvious choice for income is corporate bonds funds, which if held in an individual savings account can generate a completely tax-free income.
Corporate bond funds have been the big fund sellers of the past few months as income-starved savers try to find a way to bump up their income. Many independent financial advisers are pointing out that aside from the attractive income on offer, there is also potential for capital growth, given that yields have increased as capital values plummeted.
Corporate bond prices are building in default levels not seen since the 1930s, which many commentators think makes them a great bargain. Jim Cielinski, managing director and head of investment grade credit at Goldman Sachs Asset Management, says: "We believe corporate bonds are inexpensive compared to any other period in history. Whilst the economic outlook is bleak, credit should ultimately benefit from the unprecedented level of government intervention to repair markets. High quality securities, such as investment grade corporate bonds are priced at levels that will allow significant upside potential in the event of an economic recovery, but will also provide greater protection against the many downside risks in the global economy at the moment.
"Looking forward, there will certainly be more corporate bond defaults in 2009, but the market has already priced in this eventuality. We believe current credit spreads more than compensate investors for the potential default risk. "
Be careful about your fund choices, however, as some commentators believe this sector will give way to the most disappointments this year.
Our favourite corporate bond funds include the M&G Corporate Bond Fund and Invesco Perpetual Corporate Bond Fund.
The £2.4bn M&G Corporate Bond fund is a solid lower risk alternative to cash and gilts. The fund aims to provide a regular income and the potential for capital growth, with a lower risk than investing in equities. It seeks to produce a higher total return from investment than you would traditionally receive from gilts. It is well diversified across high quality companies, plus it has a low exposure to financials, which makes it seem lower risk. It is also supported by M&G's vast income team, headed by the highly respected Richard Woolnough, who has an AAA* fund manager rating from Citywire. Mr Woolnough can draw on 20 years of experience in fixed income investment, as well as the independent views of M&G’s 50-strong in-house credit analyst team – one of the largest in the UK.
Note that it is a defensive fund, with a focus on investment grade corporate bonds, but yielding 4.79 per cent it makes an attractive alternative to cash.
If you want a higher risk fund that can take advantage of high yielding bonds, its sister fund, M&G Strategic Corporate Bond, also managed by Mr Woolnough is a good bet. The fund aims to maximise total return through investment predominantly in investment grade corporate bonds, but may invest in other debt instruments, including higher yielding corporate bonds, government debt and convertible and preference stocks, as well as money market instruments and equities. Its 12 month yield is 4.49 per cent.
Invesco Perpetual Corporate Bond fund has a relatively high yield compared with its peers but has a slightly higher-risk strategy with higher exposure to financials. The fund aims to achieve a high level of overall return, with relative security of capital by investing primarily in fixed interest securities, though it may use other instruments.
The fund is managed by highly rated Paul Read and Paul Causer. While the two Pauls were caught out by the downturn following the Lehman episode, they do have long and respectable track records in corporate bond fund management. They also manage some funds alongside Neil Woodford, Invesco Perpetual's equity income guru. The fund's 12 month yield is 6.13.
Low cost exposure to corporate bonds can be achieved by the iShares sterling corporate bond ETF. This aims to provide investors with a total return, taking into account both capital and income returns, which reflects the total return of the Sterling denominated investment grade corporate bond market. Its 12 month yield is 8.07 per cent and its Total Expense Ratio (the percentage of the investment that you pay in fees) is very cheap at 0.20 per cent.
UK Equity income
Equity income funds make good core holdings for your portfolio – even if you are not seeking income, as dividends can be accumulated within the fund. There is a vast choice of UK equity income funds, among the best known of which are Invesco Perpetual's Income and High Income funds. Managed by Neil Woodford, the UK's most successful and best known fund manager, these funds are the first choice for many investors.
An alternative that comes heavily recommended by many independent financial advisers is Artemis Income. Managers Adrian Frost and Adrian Gosden have a wealth of experience and have implemented their investment strategy consistently over the years. Unlike other equity income funds, and to their credit, the managers have kept a light exposure to the battered financial services sector. They began to reduce their financials weighting in the first quarter of 2007 and this move worked in the fund's favour in the ensuing meltdown.
The objective of the Artemis Income fund is to achieve a rising income combined with capital growth from a portfolio primarily made up of investments in the United Kingdom. The portfolio tends to be heavily skewed towards the UK's largest companies, though it also includes a smattering of small and mid caps. The managers will include a European alternative if it holds more attraction. This is restricted to 20 per cent of the fund and currency exposure will be hedged back to sterling.
The fund's historic yield is 6.4 per cent and its total expense ratio is a reasonable 1.56 per cent.
Overseas Equity income
Investors have traditionally flocked to UK equity income funds as UK companies' strong culture of paying dividends meant there was no need to look further afield. However, times have changed and the new theme in equity income seems to be: go global. In recent years we have seen plenty of global equity income funds being launched to UK investors.
According to data from Ignis Asset Management, whose Ignis Argonaut European Income fund has a good reputation, there are more than double the number of companies in Europe with yields in excess of 3.5 per cent compared to the UK, and in the last two to three years average dividends in Europe increased by over 40 per cent - one of the fastest growth rates of anywhere in the world.
The first was Newton's Global Higher Income fund managed by James Harries, launched in December 2005. Run on a global thematic investment approach and strict yield criteria, it is a favourite of many advisers and its historic yield is 6.40 per cent.
We also like the Elite Bloxham Global Equity Income Fund which follows a conservative investment style which aims to reduce risk and volatility, while aiming to generate a high income which increases over time. The fund is globally diversified with exposure primarily to the following regions: North America, Europe, Asia, and Australasia. Fund manager Pramit Ghose has a good track record in global equity income. He has been increasing exposure to the US since the summer of 2008, taking the fund's total US holdings to 33 per cent and broadly reflecting a view that the world's biggest economy will show the seeds of recovery towards the end of 2009.
Investment trusts
Investment trusts can provide an alternative income for investors and savers. And they have advantages over open-ended funds in this respect.
"As rate cuts reach new lows, investment trusts with strong revenue reserves are able to maintain regular dividend payments, thus appealing to investors looking for a reliable income," said James Saunders Watson, head of sales and marketing for Investment Trusts at JP Morgan Asset Management.
Many established investment trusts have considerable revenue reserves as a result of their ability to retain up to 15 per cent of their annual income, rather than having to distribute it. As such investment trust boards are able to enhance annual dividend payments to shareholders by drawing on their reserves to cover any shortfall in the income they receive during market downturns, such as experienced today.
With income in mind, the Association of Investment Companies recently identified the investment trusts with unblemished records of annual dividend increases. Top of the list of investment trust dividend heroes is City of London Investment Trust which has an outstanding 42-year record of annual dividend increases, closely followed by Alliance Trust, Bankers Investment Trust and Caledonia Investments which all have 41-year records of consecutive annual dividend increases.
Particularly strong dividend performance is found in the AIC's Global Growth and UK Growth and Income sectors. Within this sector, stockbroker and wealth manager Collins Stewart's favoured stocks are Edinburgh Investment Trust and Perpetual Income & Growth. Alan Brierley, head of investment companies research at Collins Stewart, says: "Both managers have sought to construct a portfolio of companies that can grow earnings, cash flow and dividends, and there is a focus on defensive growth."
Alternatives
Commercial property doesn't exactly get investors excited at the moment as capital values have fallen over 37 per cent from their mid-2007 peak with further falls expected in 2009. However, investors with a long-term outlook and income on their agenda might be tempted by the yields on offer. A property fund would also provide an alternative income stream that diversifies away from equities and bonds.
Decent property funds include the SWIP Property Trust, which has a high yield relative to other property funds (historic yield is 4.1 per cent) and can invest 100 per cent in direct property. It also has more than 20 per cent in cash to accommodate investor redemptions and provide funds for opportunistic purchases. Manager Gary Ferguson, who has managed the trust since its launch in November 2004, says: "Following the correction in the property market, it is clear that income will be the major contributor to returns for at least the next few years.
"Therefore, our focus is to firstly secure current income flow through close monitoring of the fund's tenants, and secondly to exploit opportunities to grow that income using our asset management skills and by acquiring stock with income growth potential.
"We have assembled sufficient liquidity within the fund to allow us to take advantage of any opportunistic purchases, but our longer term view is to buy into those sectors and locations which will benefit from increasing occupier demand."
Many real estate investment trusts (Reits) are on significant discounts to their net asset values, while offering healthy, tax-efficient yields. You can buy them direct or via TR Property Investment trust, managed by Chris Turner. TR Property is a UK-based investment company, listed on the FTSE 250 index, which invests in Pan European equities and UK direct property on behalf of its shareholders. It yields 5.36 per cent and sits on a 13 per cent discount to NAV.
