Alternative income ideas for your Isa

Enhancement

However, diversifying your income doesn't only mean going abroad, as there are UK equity income funds that boost their income with derivatives.

Examples include IC Top 100 Fund Schroder Income Maximiser (GB00B0HWJ904). "This has a strong value and in more benign conditions can lag, but over the course of a cycle makes good returns," says Mick Gilligan, head of research at broker Killik. "It makes lumpy returns but benefits from income from call premiums. It aims to yield around 7 per cent and has delivered consistently."

The fund is made up of a UK equity portfolio along with a covered call strategy. The fund regularly enters into contracts under which it effectively agrees to exchange the profit on any stock exceeding a level of, say for example, 10 per cent, for an agreed fee. This premium is used to boost the income on the fund. The fund would retain any gain up to this 10 per cent level each quarter but surrender returns above that. This means it won't always capture all of the returns directly from the stocks it holds. This can be a large opportunity cost when equity markets are experiencing strong rises but the fund benefits from volatility, which contributes to higher than average option premiums, resulting in an attractive overall return.

Another example is Fidelity Enhanced Income Fund (GB00B3KB7682). "This is a traditional, defensive UK equity income fund with a similar composition to the Invesco Perpetual Income (GB0033053827) and High Income (GB0033054015) funds," says Robert Pemberton, investment director at HFM Columbus Asset Management. "But it uses a covered calls derivative strategy whereby the fund can boost its yield to around 7 per cent by forgoing some potential future capital growth in exchange for a higher level of income.

Further afield

The choice of overseas equity income funds has grown in recent years as a culture of paying dividends has grown in areas such as Europe and Asia, while investors are increasingly aware of the high dividend payers you can find in the US.

Asian equity income funds offer both income and exposure to fast-growing parts of the world. There are three investment trusts that tap into this area. The best performer over the years has been IC Top 100 Fund Aberdeen Asian Income (AAIF), though this trades at a premium of 2.91 per cent. It offers a yield of 3.06 per cent.

Henderson Far East Income (HFEL) yields 4.53 per cent and is on a 2.61 per cent premium and Schroder Oriental Income (SOI) yields 3.38 per cent on a 0.71 per cent premium (read our tip)

A popular open-ended fund has been IC Top 100 Fund Newton Asian Income (GB00B0MY6Z69), which yields 4.6 per cent and, in addition to an attractive yield, is one of the top-performing Asian funds in terms of total return over one, three and five years.

However, with all these funds you may be taking on some emerging markets risk and greater volatility, as well as currency fluctuations. The level of income may vary because companies in these region do not necessarily target progressive dividends, but may pay out a set percentage of their earnings each year.

Read more on Asian income

For exposure to US equity income, Mr Gilligan suggests the SPDR US Dividend Aristocrats exchange traded fund (ETF) (USDV). It tracks the S&P High Yield Dividend Aristocrats Index and has tracked it closely since inception. The S&P High Yield Dividend Aristocrats Index measures the performance of the highest dividend-yielding S&P Composite 1500 Index constituents that have followed a managed dividend policy of consistently increasing dividends every year for at least 20 consecutive years.

The ETF has a low total expense ratio (TER) of 0.35 per cent and yields 2.41 per cent.

Many active managers fail to outperform the mature US market, so in this region there is a good argument for using a passive fund. With current sterling weakness against the US dollar, UK investors also get an added boost from the exchange rate.

Read more on US equity income

If you want less concentrated risk, you could consider a global equity income fund that also tends to make a large percentage of its earnings in US dollars. Options include IC Top 100 Fund M&G Global Dividend (GB00B39R2M86), which yields 3.45 per cent and is first quartile of the Investment Management Association's Global Fund sector over one and three years.

Lazard Global Equity Income (GB00B24DPY79), meanwhile, delivers a yield of around 4.5 per cent and is geographically and currency diversified (read more on this).

Tony Gammon, director at Thesis Asset Management, suggests Newton Global Higher Income Fund (GB00B0MY6T00) for international exposure with lower than average volatility. It yields 4.5 per cent and is one of the top-performing global equity income funds over three and five years.

Alternative income funds

Source: Morningstar

Performance data as at 18 March

Alternative fixed income

Bond funds are a traditional source of income, although advisers suggest you review your holdings due to concerns over liquidity and valuation, as covered in Investor Chronicle, 15 March 2013. While they still suggest some traditional bond funds (click here to see which), they are increasingly directing investors to non-traditional sources.

These include investment trusts that invest in forms of debt other than corporate and government bonds - for example, corporate loans and asset-backed securities (ABS) - and with recent launches there are now around 13 of these funds listed in London.

Reasons for investing in one of these trusts include the fact that their assets are considered to be less overvalued than corporate bonds. With ABS, in particular, some of these offer good value because the whole asset class was tainted by the financial crisis as some of these bonds were backed by sub-prime US mortgages. However, the unaffected ones can offer exposure to good assets.

"In 2012, the asset-backed securities (ABS) market delivered excellent performance, and as the global economy improves further and bond yields continue to be squeezed, investors are returning to this asset class," says Laurence Kubli, manager of the JB ABS Fund. "Many investors are unaware that the issuance of ABS is not standardised across the globe and that structures vary not just between Europe and the US, but also between individual countries within Europe. The drivers that created the strong ABS market in 2012 remain in place, and there is further upside potential in vintage ABS trading below par, while the instruments remain well protected against rising interest rates from their floating rate coupons."

Another advantage is that in the case of asset-backed bonds, should there be a default investors have recourse to the underlying assets. If the fund invests in the senior tranches of debt issues, although they pay less yield, in the event of a default these will be paid back before lower-ranking debt.

Recently launched TwentyFour Income Fund (TFIF) is investing its portfolio in 30 to 50 UK and European ABS, initially targeting northern European mortgage-backed securities with a focus on investment-grade debt (considered less likely to default). It will target a net total return on its issue price of between 7 and 10 per cent a year and intends to pay a dividend at least equal to the value of the trust's net income arising each quarter. Returns from the portfolio are expected to increase as interest rates rise as a result of the floating rate nature of the assets.

Although this trust is new, it is run by Twenty Four Asset Management, which is experienced at running assets in this area.

Another recent addition to the space is ICG-Longbow Senior Secured UK Property Debt Investments (LBOW), which is constructing a portfolio of good quality, defensive, senior debt investments secured by first charges against UK commercial property investments. The trust aims to provide dividends of around 6 per cent a year paid quarterly with minimal risk of capital or income loss.

Although the trust is new, its team is experienced at running investments of this kind.

However, other than the fact that these funds are listed and offer exposure to some kind of debt investment, they are fairly different, which makes them hard to compare with each other and assess. It is very important to understand what the repayment priority is for the debt they hold. While funds like ICG Longbow are senior secured debt only and have a direct call on the UK commercial property they write the loans against, some have a mix of senior and mezzanine debt, giving a higher risk-reward profile.

You should understand and be comfortable with the approach, any currency risk and geographic exposure.

"It is always important to understand what you are investing in and be conscious of the risk profile, as these give exposure to a wide range of asset classes," says Fin Bodman, who works on the investment trust desk at Investec. "Some of the underlying investments can be fairly complex."

This is not helped by the fact that this is a relatively new asset class, so many of the trusts only have a track record of one year or less. Neuberger Berman Global Floating Rate Income (NBLS) has a slightly longer track record having, launched in April 2011, and targets senior corporate loans. However, this trust is on a premium to net asset value (NAV) of 3.94 per cent. (read more on this)

Longer established vehicles include IC Top 100 Fund New City High Yield (NCYF), which has performed strongly and yields 6.11 per cent. However, this also trades on a premium of around 3.6 per cent. City Merchants High Yield (CMHY) has also made good returns over five years and offers an attractive yield of 6 per cent while on a discount of 6.74 per cent (read our tip)

Analysts at Winterflood, meanwhile, suggest Henderson Diversified Income (HDIV). The fund is managed by John Pattullo and Jenna Barnard, who run a number of successful open-ended bond funds at Henderson such as IC Top 100 Fund Henderson Strategic Bond (GB0007495293).

The trust aims for high level of income and capital growth over the longer term and has 53 per cent of its assets in secured loans and nearly 30 per cent in high-yield corporate bonds. The fund has performed strongly in recent years as investor appetite for yield has resulted in a recovery in loan prices.

"We believe that Henderson Diversified Income's flexible mandate is attractive and the manager's ability to make relative value calls across both the credit spectrum and corporate capital structures differentiates it from its peers," say analysts at Winterflood. "The significant allocation to floating rate loans also mitigates some of the duration risk associated with an increase in interest rates."

The fund currently trades at a premium of 3.28 per cent and offers a yield of 4.7 per cent.

Alternative income investment trusts

Source: Morningstar

Performance data as at 18 March