With income choices relatively limited of late, Jenny Lowe considers the options that investors may have forgotten.

Recent events have made the search for income a difficult one as investors suffer low interest rates, made worse by the prospect of inflation and questions over the security of government bonds.

Deriving a regular, sustainable income from an investment portfolio remains one of the highest priorities for many investors, particularly for those whose savings are now earning as little as 1 per cent in the majority of high street accounts.

Still, the question remains: where can you find those opportunities, and how can you make the most of your investments if you are an income seeker?

Income can be gleaned from a wide range of assets, including equities, bonds, cash and property and, like any other portfolio, investments for income should be diversified, giving exposure to different instrument types and sectors.
Indeed, diversifying risk might be seen as especially important in an income portfolio since you may be reliant on the regular payments.

Reduced uncertainty
Bonds are especially attractive to those seeking income because their fixed income nature has historically reduced uncertainty, leading them to be considered low risk. There are also a number of specialist income funds, which invest across a spectrum of instruments.

‘We are favouring strategic bond funds at the moment,’ says Sheridan Admans, investment adviser at The Share Centre. ‘Managers of these funds have the ability to take a mixture of bond assets depending on their current economic viewpoint, and they are still seeing reasonable incomes in the region of 6 to 7 per cent.’

He points in particular to the Invesco Perpetual Income Plus fund, managed by investment guru Neil Woodford.  This fund seeks to achieve a high level of income by maximising total return through investing in high-yielding corporate and government bonds. What is appealing about this fund, however, is that it has the capability to invest 20 per cent of the portfolio in equities.

Neil Dwane, manager of the Allianz RCM European Equity Income fund, points out that ‘History clearly demonstrates over the long term that investing in equities and reinvesting the dividends produces the best returns to investors.’

Income investors often overlook equities. This is typically because most are reliant on a steady income stream and, by nature, equity-based portfolios are riskier than those with bonds used as the core.

However, there are a number of sectors that offer especially good yields, as Robin Geffen, manager of the Neptune Income and Quarterly Income funds, is quick to point out: ‘The reasons for buying equity income funds remain very compelling because, having seen outperformance of lower-quality, non-dividend-paying stocks in the third quarter of last year, the market has now rotated towards favouring quality income-generating stocks.

‘Kraft’s opportunistic bid for Cadbury is an example of a high-quality income stock that has been bid for because it was clearly undervalued. In addition, a large percentage of quality income stocks have succeeded in increasing their dividends in 2009, and we expect this to continue this year.

‘Given the low yields from cash and bonds, the yield on equity income funds remains very attractive.’Bonds, particularly corporate bonds, have recently outperformed equities, but this, according to Dwane, is not likely to continue.

‘Any potential investor should be aware that a corporate bond is essentially an IOU from the company, and they need to consider whether that company will be able to repay the debt. Also, bonds are rated by the various agencies as being either ‘investment-grade’ or ‘non-investment grade’. The latter generally offer the highest potential return but also carry the greatest risk of default.

Tineke Frikkee of Newton Investment Management agrees: ‘In many cases the yield from a corporate bond of a company will be significantly less than that from a share or equity of the company.

‘Clearly, this reflects the greater certainty of the interest being paid. However, in the case of strong companies, like BP, there remains little doubt that the dividend will be honoured and thus, why buy the corporate bond when you can buy the equity with all the attractions of it?’

Going global
But Stuart Rhodes, manager of the M&G Global Dividend fund, is keen to point out that the UK is not the only country where the equity income strategy works.

‘The most compelling argument behind income investing on a global basis is that it offers the flexibility of choice. Compared with the 1,500 companies listed in the UK, the global investor has 15,000 companies to choose from. Contrary to popular belief, the dividend culture is not unique to the UK. In fact, history shows that the best examples of financial discipline are found overseas.

In the UK, there are just three companies with a 25-year track record of consecutive dividend increases: Tesco, Halma and PZ Cussons. In the US, the world’s largest and most established stock market, there are 92 companies in this elite group of 25-year ‘dividend achievers’, including household names such as Coca-Cola and Johnson & Johnson.

‘We would argue that the best opportunities for stock-picking among dividend-paying companies are not just in the US, but also in Europe and countries further afield such as Australia and Brazil.’

It is important, when putting together your income portfolio that you consider future implications, such as the end of quantitative easing, another dip in equity markets or – the one that many city analysts are now believing is more than likely – rising inflation.

Economic woes
Leigh Harrison, manager of the Threadneedle UK Equity Alpha Income fund and the Threadneedle UK Equity Income fund, continues, ‘The issues in the economy are by no way resolved. One view would be that the amount of government debt and the level of refinancing activity that has to go on is going to have an impact at some point.’

Of course, we are currently experiencing record lows when it comes to inflation, but this won’t continue to be the case. At some point, inflation will rise, and if you haven’t taken measures in your portfolio to protect against this then your income could be adversely affected.

Investors worried about inflation are typically advised to buy real assets, such as commodities or property, while index-linked bonds such as government bonds or products from National Savings & Investments also protect income against rising inflation.

The Share Centre’s Admans believes that when it comes to getting exposure to real assets, investors should give some consideration to the First State Global Listed Infrastructure fund, which allows you to both grow the capital invested and protect your income against inflation by investing in listed infrastructure and infrastructure-related securities.

It is possible to buy index-linked gilts, which typically rise in line with inflation, but for the private investor this can come with a price tag and, should inflation not rise substantially, this could leave you suffering a loss.