Four fund options if you're moving out of cash

Last week we found fixed-rate bondholders teetering on the edge of a precipice as their policies matured - all because rates have plummeted by up to 2.5 per cent on some products. The best three-year fixed-rate bond from ICICI Bank now pays a measly 2.55 per cent annual equivalent rate (AER), letting your cash fall miserably behind inflation.

And new Zopa research reveals rock-bottom rates will leave the average saver £54 out of pocket by the end of the year for every £3,500 they have tucked away in a cash individual savings account (Isa). All because their account would have seen interest payments of only £23 last year, but when you take inflation into account, the value of these savings would have declined by £77.

But this isn't a new phenomenon - it's been dragging on for years. UK interest rates have been at a record low level of 0.5 per cent for four years, and in that time most cash savers have been losing money in real terms.

And the real effect of inflation is actually much worse. It's likely your personal rate of inflation far exceeds official rates because the things you buy on a day-to-day basis are getting even more expensive. Older people in particular will spend a higher proportion of their money on items such as food and utilities, which tend to rise faster in price than inflation. And since elderly people tend to be more reliant on savings accounts with paltry rates - the combination serves as a nasty double whammy.

Patrick Connolly, head of communications at Chase deVere, says the most cautious investors should remain in cash. He recommends regularly reviewing your accounts to ensure they are earning competitive rates of interest. You should also remember to use your annual cash Isa allowance, which for 2013/14 is £5,760. By saving in a cash Isa you can ensure all interest you make on your money is tax free.

However, if you're a cautious investor and you're determined not to be beaten by the cruel cash rates, what other options are out there? Unfortunately there is no magic bullet out there for income seekers who aren't prepared to ramp up the risk in their portfolio.

The financial services industry is well aware that investors are hungry for income, and there is an abundance of new products emerging to satisfy the growing demand. But unfortunately many of them come with big risks attached - risks that are too big for most investor's tastes. In general, financial advisers say you should steer clear of anything that's investing in small companies you've never heard of - like schemes that invest in wind farms, or aeroplanes - even if they guarantee huge yields - as the risks involved could be massive.

 Here's a selection of options that will allow you to increase your income, while keeping the extra risk you'll have to take on to a minimum:

UK Equity income funds

Income investors looking to invest in shares should take a look at UK Equity Income funds. They are often invested in large companies that are making consistent profits and paying dividends to shareholders - and these are paid out to you as an owner of the fund. Ben Yearsley, head of investment research at Charles Stanley has been buying what he calls "stodgy income stocks" such as BP, BT, Shell, Sainsbury and Astra Zeneca for his own Isa. He likes them because they are on single-digit price to earnings ratios, are yielding 5 per cent plus, and they have consistent cash flows and repeatable revenue and dividends.

UK equity income funds can give you exposure to these sorts of companies and are a good way to beat inflation as there are a good selection of them which currently yield a higher rate. But don't focus solely on the yield as the ones with the highest sometimes come at the expense of capital gains - which is a really important part of the total return. Threadneedle UK Equity Income (ISIN: GB00B3L6GM14) is a first quartile performer over three years with a 60.3 per cent return and a current yield 3.5 per cent. And Artemis Income (ISIN: GB00B2PLJJ36) has a slightly higher yield at 3.9 per cent but hasn't done as well in terms of total returns - having only managed a second quartile performance of 49.8 per cent over three years.

If you are seeking a higher level of income, the Schroder Income Maximiser fund (ISIN: GB00B0HWJ904) is worth considering. It's run as a typical equity income fund, except that some of the capital growth upside is sacrificed in order to boost the income. This means that the fund is likely to under-perform when markets are rising, but it is designed to do comparatively well when they are falling. It’s currently yielding an impressive 7.0 per cent.

Global equity income funds

These have proved popular as the second best selling type of fund for UK investors in recent months. Income investors can use them to spread risks by getting international diversification - rather than just limiting themselves to the UK. Mr. Connolly likes the Newton Global Higher Income fund (ISIN: GB00B5VNWP12) as a good core holding. It's a US-heavy fund with further exposure to the UK, Switzerland, Holland, Germany and France and a strong 4.1 per cent yield. Among its core holdings are Reynolds American, Philip Morris International, Microsoft Group and Sysco Corp.

You can also find income in developing markets - although note the extra risk you'll be taking on. If you'd like an Asian injection into your portfolio Newton Asian Income (ISIN: GB00B63QPN46) is a strong contender. It's consistently thumped its benchmark index (Asia ex Japan), is a first-quartile performer over one and three years and has a healthy 4.7 per cent yield. It's heavy in financials and telecoms with core holdings in Telstra Corp, HSBC and Taiwan Semiconductor Manufacturing.

And if you're after a meatier yield, Schroders also has an Asian Income Maximiser fund which is currently yielding 7.0 per cent - although the overall performance doesn't look as good as the Newton fund despite having many of the same core holdings.

Bond funds

Bonds can be a good and reliable source of income because they are basically fixed IOUs that pay steady interest. They are usually more secure than equities but there are still risks attached. The problem is it can be difficult to invest in the safest forms of fixed interest - like as gilts - and still yield more than the rate of inflation.

If you're hunting for income it might be tempting to go for super high yielding bond funds - but this could be a mistake if you don't have a big appetite for risk in your portfolio.

High-yielding bond funds tend to invest in esoteric, sub investment grade companies in order to get the highest payouts - but this means they are taking credit risks because those companies could stop paying out at any moment if they run into trouble.

If you're willing to take a moderate amount of risk, strategic bonds funds could be a good idea - and they are the favoured approach of financial advisers. They still invest in risky companies with B or CCC credit ratings, but the manager has the ability to hedge the risk so you get some protection. Andrew Birt, financial planner at Saunderson House likes the Henderson Strategic Bond fund (GB0007495293) and Jupiter Strategic Bond fund (GB00B2RBBC80). Henderson's offering has a 5.7 per cent yield and has Ziggo Bond Co, Daily Mail and Alliance Boots as its biggest holdings, while the Jupiter fund offers 6.1 per cent and has different types of Australian government bonds as all of its top three holdings.

These funds produce decent yields but the managers are very good at being flexible over where they invest, so they can change their portfolios to suit the economic environment as well as investors' needs.

Structured products

Structured products have fallen out of favour recently because largely unforseen downside risks have come back to bite chunks out of investors’ returns, causing widespread disappointment. Structured products are investments where the returns are defined by reference to a defined underlying measurement (such as the FTSE 100 index) and delivered at a defined date.

Jason Hollands, head of business development at Bestinvest, says both institutional and retail and structured products aren't offering particularly good value at the moment, and says there aren’t any real options for investors moving out of cash.

But not everyone agrees with him. There are some strong returns to be had from structured products at the moment, according to Adrian Neave, managing director at Gilliat Financial Solutions. He has managed to produce 12 - 13 per cent yields for some of his structured product clients this year - not without them taking a substantial amount of risk though, he admits.

Mr Neave says the best option for people coming out of cash that don't want to take much risk is structured deposits - an investment whereby your return is determined by the performance of an index, but you can't 'lose' money as the least you'll get back is your original investment without interest. However, if the product has a long life, annual charges, and you're not getting any returns, you'll have lost out in real terms as inflation will have devalued your money in that time.

Investec's FTSE 100 Target Income Deposit Plan 5 is the income-providing structured deposit preferred by Lowes Financial Management - who sell it for a fee of 1.65 per cent. It pays 5 per cent income a year on the condition that the FTSE 100 Index is above 90 per cent of its value a year after you invested, plus any rolled-over income payments that have not yet been paid. And you get your net invested capital back when the policy matures after six years - although if you try to take money out before then, you'll incur a penalty. And if the FTSE 100 Index is below 90 per cent of its initial level on each anniversary, you just get your net invested capital back.

Societe Generale and Credit Suisse are also well known for these types of products.

Performance of income providing funds