The Bank of England’s decision to keep interest rates low means that many savers will now receive virtually no return from their money. As a result, many will be looking for alternative homes for their nest eggs. If you are considering building a portfolio of income-producing funds, your first priority should be to decide the level of risk you’re happy with and the investment term. Let’s consider some of the options available.
Government gilts
Gilts are government bonds. Governments borrow from you, pay a fixed interest rate and then pay you back on a fixed date. Gilts involve more risk than cash because there’s a chance the government won’t be able to pay you back. It’s highly unusual for a government to default on a debt, so they have been considered very safe – however, in the current economic climate, this risk increases.
Not all gilts are bought from the government and held to maturity; some are bought and sold along the way, so there’s a chance for their value, and the value of gilt funds, to rise and fall.
Corporate bonds
Corporate bonds are the same as gilts, except that instead of lending money to the government, you’re lending to a company. The risk lies in the fact that companies can get into financial difficulty and the debt may not be repaid. Also, the value of the bonds themselves can fall as well as rise. The fact that bonds are riskier at the moment means some companies may pay more in order to induce people to buy their debt.
Also, an increasing number of global bond funds are entering the market, which may enable investors to acquire value from a lot of different markets.
Equity income funds
Equity income funds invest in shares, focusing on the big blue-chip firms that have a track record of good dividend payments. The dividends are your income.
You are investing in shares. Funds tend to focus on those firms they believe have cash in the bank to keep paying dividends, but there are no guarantees. In return for taking these risks, there is potential for both income and growth. Typically, funds aim to provide a stable income that grows over time, meaning income has the potential to rise in the future too, which is key to the philosophy of investing in equity income.
Global equity income funds
Global equity income funds are similar to UK funds, except that there are only a handful of
big blue chips that pay reliable dividends in the UK, whereas global diversification offers a larger range of companies to choose from.
If you consider that you have too much of your investment concentrated in sterling-based assets, a global fund could provide a useful diversification. However, investing in other currencies brings an added level of risk, unless the fund hedges the currency.
Equity income investment trusts
Equity income investment trusts are very similar to other equity income investments, but they are structured differently from the unit trusts and open-ended investment companies. Unit trusts are open-ended, which means there’s no cap on how much money the fund can take, so the price depends purely on the value of the assets it holds.
Investment trusts, on the other hand, are closed-ended. They are structured as companies with a limited number of shares. The share price of the fund moves up and down depending on the level of demand, so the price of the trust depends not only on the value of the underlying investments but also on the popularity of the trust itself. In difficult times, when investors are selling up, trusts are likely to see their share price fall more than the value of their underlying investments. This also means that they have more potential for greater returns once better times resume.
Distribution funds
Outside the basic asset types, there are a number of products designed to produce an income. These include distribution funds, which sit somewhere between bonds and equities on a risk-for-return scale. They are managed funds, investing in a combination of bonds, equities and commercial property in order to produce an income. Typically, investment is split between dividend-producing equities and corporate bonds.
The value of investments and the income from them can go down as well as up and you may not get back your original investment. Past performance is not an indication of future performance. Tax benefits may vary as a result of statutory change and their value will depend on individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent finance acts.
