High-income funds for your Isa

Equity income funds are usually the first port of call for Isa investors looking for income. The average 12-month yield for the IMA UK Equity Income sector is 4.21 per cent, but the sector includes some enhanced equity income funds, with a significantly higher yield. We include two of these in our IC Top 100 Funds: Fidelity Enhanced Income (GB00B3KB7799), which has a 12-month yield of 5.9 per cent, and Schroder Income Maximiser (GB00B0HWHK75), which has a 12-month yield of 6.7 per cent.

Read our tip on Fidelity Enhanced Income

Schroder Asian Income Maximiser (GB00B3SB3287), meanwhile, yields 9.2 per cent.

In this article all the yields quoted are 12-month yields sourced from Morningstar on 21 March.

However, with enhanced equity income funds you trade capital for income and sacrifice some growth. "These create the opportunity for some income growth," says Brian Dennehy, managing director of fund research website FundExpert.co.uk. "But income growth will be sacrificed to a large extent compared with a pure equity income fund."

Enhanced equity income funds typically use a covered call strategy, whereby the fund regularly enters into contracts under which it effectively agrees to exchange the profit on any stock exceeding a level of, for example, 10 per cent, for an agreed fee. This premium is used to boost the income on the fund but if the market rises sharply the fund will not participate.

Necessary sacrifice

If you are targeting a high income you risk sacrificing capital value, which detracts from your total returns. And some investments have a high yield for a good reason: they are high risk.

"The top 50 yielding funds run from 5.5 per cent up to 8.5 per cent," says Mr Dennehy. "The great majority are high-yield bond funds and emerging markets debt funds: there are valuation risks with high-yield bonds, and quantitative easing tapering risks remain with emerging markets debt. As such, they are of limited value to long-term income-seeking investors as the income does not grow over time (unlike equity income funds). High-yielding bond funds have high yields for a reason - there is more risk."

The main risk with high-yield bond funds is default, but at the moment they don't yield that much more than corporate bonds, according to Adrian Lowcock, senior investment manager at Hargreaves Lansdown. He feels these and emerging markets debt funds do not compensate you well enough for the extra risk.

However, you can mitigate risks by holding higher-yielding bond funds as part of a diversified portfolio. And you do not need to hold funds purely focused on high yield to get a better income: IC Top 100 Fund Henderson Strategic Bond (GB0007495293), yields 5.79 per cent and has almost 30 per cent of its portfolio in investment-grade corporate bonds.

See more strategic bond options for your Isa

Meanwhile, funds with 'higher income' in the name are not necessarily the case despite their name. Prominent examples include Invesco Perpetual High Income (GB0033054015), which has a yield of 3.55 per cent, similar to Invesco Perpetual Income (GB0033053827), with a yield of 3.47 per cent.

IC Top 100 Fund Newton Global Higher Income (GB00B0MY6T00) yields 4.74 per cent, which is not that much higher than some standard equity income funds. It aims to provide growth in income and capital over time However, given the current defensive positioning, the fund should be better at protecting investors in a falling market, says Mr Lowcock.

Things to watch

Mr Lowcock says with plain-vanilla equity income funds, if there is not an obvious reason why it yields more than its sector peers, this is worth investigation.

"The key is to be wary of chasing yield," he says. "Protecting and growing your capital is one of the most important things. If you can take a step down in terms of your yield in the short term, it could be the best position for the long run. Always try and avoid going aggressively down one path or another (just income or just growth). A good equity income manager typically holds higher-yielding shares which will re-rate, or companies where yields are low but the rate of growth is not fully recognised."

Mr Lowcock says that investors should generally look for the yield on their investments to grow to try and stay ahead of inflation.

Mick Gilligan, head of research at stock broker Killik & Co, suggests balancing the income part of your portfolio across a number of areas. Your time horizon will dictate how much is allocated to equities and bonds: the longer your time horizon, the more you can allocate to equities. "This gives more scope to grow capital over time and beat inflation," he says. "But you will need to suffer more volatility to grow capital over the long term."

Mr Dennehy agrees that income growth is absolutely vital in the long run, and adds that investors need to grasp the power of compounding payout increases. "For example, if you are in a fund increasing its income by 10 per cent a year your income will double in seven years," he says. "But if you are not monitoring your fund choices closely, and your fund is only increasing payouts by 5 per cent a year, it will take 14 years to double - many will not even be this good."

Mr Lowcock suggests trying to work out what yield you need (rather than want) and initially build a portfolio to meet this, and then thinking about whether you can increase to the level of yield you want.

Growth for income?

An option is to invest in growth funds or lower income funds with a growing yield and sell them as you need income. "One of the biggest challenges with this is guaranteeing growth," says Mr Lowcock. "This is probably an option before you retire because you have to wait for a few years for it to build up. And some strong growth investments, such as smaller company funds, are good but you have to be able to tolerate sharp falls. If you are retired, most of the time this is not an option. This, of course, doesn't mean you can't have growth investments in retirement - just not high-octane ones."

Read more on funds for income drawdown

Read more on investment trusts and ETFs for drawdown

Mr Gilligan adds that a problem with selling growth investments to create an income is that you do not have predictability from one year to the next.

Overseas income funds

One of the highest-yielding equity income funds that doesn't have a derivative overlay is Henderson Asian Dividend Income (GB0003243465), with a 6.7 per cent yield, says Mr Dennehy. This has an ongoing charge of 1.55 per cent.

Its manager, Mike Kerley, also runs Henderson Far East Income (HFEL) investment trust, which yields 5.9 per cent but has a slightly lower ongoing charge of 1.33 per cent.

But this trades at a premium to net asset value (NAV) of 1.77 per cent in contrast to its 12-month average of 1.05 per cent. And while this fund yields more than its sector peers, IC Top 100 Fund Aberdeen Asian Income (AAIF) on 4.3 per cent and Schroder Oriental Income (SOI) (an IC tip) on 4.5 per cent, its three- and five-year share price returns are not nearly as strong.

Charles Cade, head of investment companies research at Numis Securities, suggested Schroder Oriental Income as an income option in our Isa special issue on 7 March. It has delivered dividend growth of 7.5 per cent a year since launch in 2005, and typically trades at a premium to NAV but can currently be picked up on a discount of 4.56 per cent.

Read Mr Cade's comment

Alternative income funds

Tim Cockerill, investment director at Rowan Dartington, says another equity income option is BlackRock Commodities Income (BRCI), which yields 5.6 per cent and is on a premium of 1.41 per cent, which is small compared with some higher-yielding investment trusts. Key holdings include large energy and oil companies such as Chevron and BHP Billiton (BLT).

He says you could also try JPMorgan Global Emerging Markets Income (JEMI), which we include in our IC Top 100 Funds. This yields 4.7 per cent and again the premium of 2.6 per cent is relatively small. This is because emerging markets are out of favour.

Also in the investment trust sector, (IC Top 100 Fund) New City High Yield (NCYF), which yields 6.4 per cent, has increased its dividend for the last seven years and it is well covered. The trust also has significant revenue reserves.

It trades at a premium to NAV of 5 per cent but has consistently, according Monica Tepes, investment companies analyst at Cantor Fitzgerald.

Read her full comment

Mr Gilligan says in addition to bonds and equity income you should hold some other asset areas for diversification. The problem with many property investment trusts, though, is that they trade on high premiums to NAV. "Be mindful of investing in property vehicles on very high ratings as interest rates are likely to be higher in three years' time," he advises.

The yields on these might not seem as attractive in a higher interest rate environment and the premiums could fall.

But Mr Gilligan says that GCP Student Living (DIGS) is one to watch. It is currently on a premium of 9.76 per cent and is expected to do a capital raising of between £30m and £43m in the next few months. This could offer an opportunity to get in at a lower premium to NAV. This trust invests in completed student living and has high occupancy rates. It currently yields 6.3 per cent.

Another way to diversify is with infrastructure investment trusts. "These provide exposure to actual projects and the income stream is very secure," says Mr Cockerill. "However, the capital growth is modest and these all trade at a premium to NAV. And you are buying into quite a specialist sort of vehicle. These also incur political risk and changes of this kind can change the investment landscape quickly."

But he adds that if you want the characteristics these types of trust offer, you have to pay for it, and if you need the regular and predictable and income, in some cases it can be worth it. Some of these trusts trade on double-digit premiums, but John Laing Infrastructure (JLIF), which yields 5.3 per cent, can be picked up at around 9.48 per cent.

Performance of recommended income funds

Source: Morningstar, *Fund provider.

Performance data as at 20 March 2014

Performance of recommended investment trusts

Source: Morningstar & *AIC

Performance data as at 28 February 2014