Tamsin Brown finds that investors searching for a tax-free income are going to have to take on more risk

With interest rates nearly hitting the floor, cash is definitely not king. Investors could be forgiven for considering stashing money under their mattresses rather than putting it into a deposit account offering such a meagre interest rate.

Those looking to invest in a cash ISA at the moment will be lucky to find one offering much above the rate of inflation. Therefore, ISA investors seeking a tax-free income this year have to be prepared to take on a little risk if they want their yield to do more than just keep up with the increase in the cost of living.

Focusing on bonds
For the many that saw the value of their investments dramatically shrink last year as a result of the rout in the financial markets, this will understandably sound daunting. But experts believe savers should be able to make an attractive tax-free income by putting a corporate bond fund or two into their ISA shopping basket.

Of course, the global financial turmoil has resulted in corporate bond prices being driven lower by troubled hedge funds liquidating their positions as well as fears that companies will default on their debt repayments. But this fall in capital value has created some very tempting yields on bond funds. And it has also left the door open for a rally in the underlying bond prices once the current liquidity issues ease.

Gavin Haynes, investment director at Whitechurch Securities, reports that ‘Our top pick in the current climate is going to be fixed interest, with a focus on corporate bonds. I think that the yields are exceptionally attractive. They are pricing in a very negative scenario regarding defaults.’

He likes the M&G Strategic Corporate Bond fund and the Standard Life Select Income fund. But he also cautions that ‘[Bonds] are not risk-free investments. You just have to look at last year – there was a large move away from this area and people became very risk averse, so there was quite a considerable drop in prices.’

An element of risk
Haynes adds, ‘Sentiment is still very negative, and it is impossible to say whether we have reached the bottom. But the yields are compelling compared with cash and government bonds. Those prepared to take an equity-style risk could look at high-yield bonds.

They are more akin to the risk in an equity portfolio but the yields are exceptional in some of these bond funds.’ However, he stresses that high-yield bonds are for the speculative investor and advises that ‘For those for whom income is a priority, stick to the investment-grade area.’

The dire performance over the past year means the corporate bond market is now pricing in a depressing doom-and-gloom scenario. Corporate bonds rated at the bottom end of the investment-grade ladder are implying that more than a third of the companies that have issued the bonds will default on their interest rate repayments.

This causes Tim Cockerill, head of research for Rowan & Co Capital Management, to observe, ‘If that is where you think it is going,maybe you should buy a gold bar, dig a hole in the garden and put it there. But if you want to focus on income, corporate bonds are well worth looking at.’

Meera Patel, senior analyst at Hargreaves Lansdown, adds, ‘Bonds are pricing in default rates of 35 per cent, and even during the Great Depression of the 1930s default rates on investment-grade bonds never rose above five per cent.What we are looking at is an attractive valuation on bonds – a lot are being priced under par – and you get a juicy yield.’

Strategic thinking
Certainly, bond funds are currently offering yields in some cases of over ten per cent. But the flipside is that the higher yield reflects a greater chance of some of the portfolio defaulting on bond payments and potentially becoming worthless.

Patel points out, ‘If you do suffer a default in some cases, the advantage of investing in a fund is that you will be in a diversified portfolio.’ But she believes it is worth waiting a few months before diving into the highyield end of the spectrum.

She also thinks it is worth considering a strategic bond fund. ‘They move around the whole market and will try to capitalise on the opportunities as they arise’.

Jacqueline Kerr, head of mutual fund investments at Standard Life Investments, is another advocate of corporate bond funds for ISA investors seeking income. ‘With investment-grade corporate bonds, you are now getting a significant yield premium over that of gilts. It may take some time for capital value to increase in the underlying assets but you will be compensated with that income.’

She adds, ‘The other area you see opportunity is the equity income space, which may seem strange because people are concerned about dividends coming down, but our UK equity high-income fund is yielding 5.2 per cent.We are looking at a very low interest rate environment and, even if you see some capital volatility, you will still be getting that income stream.’

Longer-term considerations
The disadvantage of equity income funds is that they don’t have the same tax advantages on the yield when held in an ISA wrapper. Investors still have to pay ten per cent on the income. But higher rate taxpayers escape paying the 32.5 per cent tax rate they would normally be hit with.

James Davies, investment research manager at Chartwell Group, says, ‘Equity income funds have historically yielded less than corporate bond funds, but over time you get a rise in capital that hopefully outperforms bonds.’

He adds, ‘Our base view is that people should combine a number of different types of investment funds. The Fidelity Extra Income fund is our high-yielding fund of choice, but we also like M&G Optimal Income, which has the freedom to invest a small weighting in equities.’

Corporate bond and equity income funds are not for everyone, and a cautious investor, looking for a tax-free income,may consider a fund that invests in government bonds. These are yielding between three and four per cent, which is clearly not enough to live off but gilts are seen as a safer option and the yield is clearly ahead of inflation since its recent fall. The downside to gilts is the fact they had such a good year in 2008 and many now believe they look overpriced.

Whitechurch’s Gavin Haynes argues that ‘You have seen such a flight to safety within the fixed income market, and because of that, prices have gone up and yields have fallen. They are effectively pricing in deflation. The yields on government bonds are pretty disappointing.’

For those investors anticipating Armageddon in the financial markets, there is always a cash ISA, but the overwhelming message from financial experts is that corporate bonds are worth looking at if you can stomach some risk.