Income investors have the advantage of having a clear idea of what they want their portfolios to achieve. Adrian Locock of Bestinvest asserts that ‘If your objective is to generate income, then that has to take precedence over any other investment choice. You have to look at where your current portfolio is, how much you have to invest and how much income you want to generate.’

Now is certainly an opportune time for investors to be concentrating on income, as recent market volatility has created opportunities. Traditionally, retail investors have focused on the income generated by equity investments and this remains a sensible long-term strategy, despite short-term volatility.

Time to buy income
As Tony Stenning, managing director of UK Retail at BlackRock, points out, ‘Recent market stability may easily give way to further volatility. But interest rates have been cut and investors could do well, on a three- to five-year view, to choose funds exposed to stocks with attractive dividend yields, of which there are now quite a few.’

He adds, ‘Investors should consider stocks offering above-average dividend yields. The dividend yield on the FTSE All Share is around the yield level of ten-year government bonds. Historically this has been a buying signal for equities. Why? Simply because the yield on shares is likely to rise while the income on government bonds is fixed.’

However, there are strong arguments for looking at corporate bond-based investments as a source of income. Tim Cockerill, head of research at Rowan & Co, points out that ‘If you are trying to generate an income, then at the moment ISA investors have an interesting opportunity in corporate bond funds. With the significant widening of spreads that we have seen in the corporate bond sector, income investors should probably be looking at some of these funds.’

He adds, ‘There is always the question of how much risk you are taking with these investments, but you don’t have to push the boat out too far at the moment to find corporate bond funds yielding between six per cent and 6.5 per cent. And you have some portfolios with relatively high proportions in investment grade bonds yielding seven per cent or more.’

Tim Cockerill stresses that income investors with mature ISA portfolios can take advantage of these opportunities: ‘It is also important to view the process of investing in ISAs as not simply putting new money in, but you can also look at rearranging your existing ISA investments, to take advantage of the corporate bond situation.’

Managing the risks
Many investors will associate these higher-yield levels with an increased risk of default, on the grounds that you don’t get something for nothing and higher returns in the bond markets are usually directly related to higher risks.

But Cockerill argues that ‘The point is that you don’t have to go too far up the risk scale to achieve these yields although, of course, some of these funds are not with out risk. And if you don’t want to take on the risk associated with the corporate bond market, or you have sufficient exposure to corporate bonds already, then you should look at equity income funds.’

He adds, ‘Equity income had a bit of a rotten year last year but it is still a valid investment strategy. UK equity income funds are still the place to go if you are looking for an income that can beat inflation and that will grow year on year. Of course, equity income isn’t as attractive as it used to be within an ISA, but you still have the advantage of tax free capital growth.’

One very useful tool for determining which income fund to choose is the annual ‘White List’, produced by financial adviser Principal Investment Management. This is a study of UK equity income funds that highlights the 12 funds that have delivered the most attractive combination of consistent total returns and risk, as measured by volatility, over the past five years.

Charles Brand, director of managed funds at Principal Investment Management, observes that ‘The current mood of panic has changed the complexion of the market in favour of equity income funds. Twelve months ago, income investors were bemoaning
the lack of bargains as dividend yields were converging across all kinds of stocks and sectors. Now, equity income fund managers have a plethora of cheap stocks on high yields to choose from.  The next three months are going to be tough, but in 18 months’ time it will all look very different and equity income investors could be the beneficiaries.’

Rising stars
Focusing specifically on the current White List constituents, Brand says, ‘The most exciting new entrant is Neptune Income. The manager, Robin Geffen, is unusual in running an aggressive portfolio of only 33 equally weighted stocks, but has deftly sidestepped weakness in the bank sector.’

He adds, ‘We first recommended Artemis Income in  January 2001 and the process employed by Adrian Frost on the fund continues to serve investors well. We would also highlight Invesco Income and Higher Income, run by Neil Woodford, who currently describes his  portfolio as “defensive”.’

Just as important, however, are the underperforming funds on Principal’s ‘Black List’. Brand explains that ‘The Black List identifies funds that have consistently failed their unit holders and have cost investors real money in lost performance. Equity Income investing is a specialist task and few managers have the talent to succeed. However, hanging on to the “untalented” can be costly.  We would particularly highlight HSBC Income and AXA UK Equity Income as current sell candidates.’

A balanced approach
There are managed-fund options that combine the two approaches to try to deliver a higher level of income with a greater degree of stability. A good example is Schroder Income Maximiser, which appears in the specialist sector and uses derivatives to reduce volatility and maximise yield, and is currently paying an annual yield in excess of seven per cent.

The fund’s manager, Richard Lloyd, observes that ‘Investors looking for a higher income from UK equities will find that the current annual dividend yield on the FTSE 100 is 3.53 per cent. Schroder Income Maximiser targets a stable high-gross yield of seven per cent for investors by combining an actively managed portfolio of higher-yielding UK stocks with a covered call option overlay strategy to maximise income. The fund also offers investors the potential to benefit from long-term capital and income growth.’

He adds, ‘As concerns about the economy and corporate profits continue, we are confident that the types of companies we favour in Schroder Income Maximiser – those with high yields, cheap valuations, strong balance sheets and resilient earnings streams – offer investors defensive characteristics as well as attractive opportunities in absolute terms. By adding an option overlay to this approach, we offer investors an additional layer of defensiveness while delivering a regular target income of seven per cent-plus per year.’