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Playing the yield

Savings accounts are no longer an attractive way of generating sufficient income in the current environment of falling interest rates. Investors are turning elsewhere for higher levels of income.

For clients looking for a balance of income and growth, many investment managers offer distribution funds. These are generally cautiously managed funds designed to pro-vide income and growth within low-risk parameters.

Distribution funds provide income through typically twice-yearly distributions to investors. The level of these distributions varies and will depend on the objectives of the fund. A good benchmark is a fund which provides a level of income that aims to exceed the interest generated by the highest-rate savings accounts over the medium term. Such a fund should also aim to provide some growth.

The asset mix to achieve this will also vary but a mix of top quality UK equities and both conventional and index-linked gilts is commonplace.

To meet the requirements of the distribution fund sector, there is a need to meet a minimum yield for the fund. For example, a fund&#39s fixed-income investments could be concentrated at the shorter, less volatile end of the spectrum under a five-year maturity range. The asset mix creates solid long-term investment performance by taking the best of both worlds and investing in a diversified portfolio of both equities and bonds.

The theory goes that whenever equities are suffering, bonds perform well and vice versa. In addition to conventional bonds and equities, some distribution funds have exposure to the property market and different types of gilts to help with the yield requirement.

For example, index-linked gilts help to form a gilt cushion as they offer guaranteed inflation-beating returns. Although the market price can fluctuate, no other form of UK investment offers the ability to stay one step ahead of inflation.

With an asset mix such as this, balanced funds produce consistently good returns even in times of high market volatility and most aim to provide a yield of around 5 per cent.

There are an increasing number of investors looking for a high monthly income who do not need to protect their capital. They are turning more and more to high-yield corporate bond funds.

Until the 1990s, this market was relatively small and high-yielding bonds were issued mostly by former investment-grade companies whose credit had declined and start-up companies which were unable to borrow from banks. Today, high-yield bonds are more commonly used to provide working capital for growing companies.

Since bond prices generally move counter to the direction of interest rates, rising rates cause bond prices to decline and bonds with a longer maturity are the most vulnerable. At the same time, a bond can be influenced by downturns in the economy and virtually all types of high-yield bonds are susceptible to economic risk.

In recessions, high-yield bonds typically lose more principal value than investment-grade bonds. There is also a default risk which is reflected in the bond&#39s credit rating. Despite this, high-yield bonds continue to carry an historically lower risk to capital than equivalent equity investments.

The focus of the high-yield corporate bond fund is very much on the provision of income. The higher the income, the more the capital is at risk. However, capital appreciation is not unheard of and positive events in the economy, industry or issuing company can reward the investor with an increase in the bond price.

High-yield bonds are considered to be a separate asset class and using one within a portfolio is a good way of diversifying risk and boosting the yield on the portfolio. There are many funds of this type being launched. The range of quoted yields varies from 7 per cent up to around 10 per cent a year. The higher the yield, the higher the risk to capital and the selection of the bond is critical not only in terms of the yield but the likelihood of the yield being maintained and the capital being preserved.

It is a market where a fund manager with resources and expertise is essential.

There is no such thing as a completely safe investment fund but, if you are looking for more income than an average savings account can give your clients, with the potential to grow the capital, a distribution fund has to be a consideration.

Over the years, it has proved to be a reliable vehicle which has cushioned investors against a range of volatile markets. On the other hand, for clients who are looking for a high level of income and are happy to accept some risk to capital, funds that invest in high-yield corporate bonds are a good option.

In these volatile times the choice of fund and, therefore, fund manager is an important consideration for the client. Being able to sleep at night is a strong motivator both for client and adviser.


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