How to cash in on an ailing market

In tough times, high-yield stocks look very attractive – but they are risky, warns Rob Griffin

Volatile stock markets may have caused share prices to plummet over the past six months but it has presented a glorious opportunity for those seeking high rates of yield from their investments.

The fall-out from the US sub-prime crisis and the subsequent credit crunch, along with widespread economic uncertainty, has badly hit a string of traditionally popular industries such as banks, housebuilders and retailers.

But valuations have fallen so far that many of these companies now look ridiculously cheap and are starting to catch the eye of investors, says Juliet Schooling, head of research at Chelsea Financial Services.

"As the markets have fallen, so yields have risen and this means equity income once again looks attractive," says Schooling. "Fund managers that have strong yield criteria are finding that many more companies are now in their universe."

Geoff Penrice, a financial adviser with Bates Investment Services, agrees. The past few months have resulted in the very unusual situation of a wide range of equities actually yielding more than gilts. "It started with the banking sector, but has now spread to other areas," he says. "Ten-year gilts are returning around 4.45 per cent, whereas BT is yielding 6.9 per cent, William Hill 5.8 per cent and GlaxoSmithKline 4.9 per cent."

But that doesn't mean that investors should get carried away, warns Ben Yearsley, investments manager at Hargreaves Lansdown. High-yielding stocks usually offer what they do for a very good reason. "They don't have a high yield just for the fun of it – normally the company has had a problem and the stock market is extremely negative on the share price prospects," he points out. "If the yield is high, the market often believes that the growth or profit outlook for that company is poor or that the dividend will be cut in the near future."

Carl Stick, manager of the Rathbone Income Fund, agrees that investing in high-yielding stocks should come with a health warning. "Any desire to go after yield has to go hand in hand with the recognition that you are going against current market trends," he says. "You'll be taking a gamble as the market is out of love with them and you don't know when this will change."

So how can investors protect their dividends? Well, that is virtually impossible for those investing in individual stocks, says Yearsley. The only alternative is to buy a fund – such as one in the Equity Income sector – that invests in a number of names.

"Having a portfolio of shares does protect the yield, but only through diversification," says Yearsley. "Funds offering a high level of income at the current time include Liontrust First Income, which is yielding about 6 per cent."

However, this is still no guarantee of success – as can be illustrated by the performance of most funds over recent months. It is certainly fair to say that the UK Equity Income sector has had a very rough time of late. The average return for one of its 90 funds over the past three months is -10.9 per cent, according to Morningstar figures.

Even the best performer – the CF JM Finn UK Portfolio fund – is in negative territory to the tune of -5.4 per cent. The worst, an unwanted accolade currently held by New Star's UK Strategic Income fund, has lost a whopping 15.5 per cent. Figures over the past year to the same date tell a similar story. Average returns range from -4.1 per cent to -27.5 per cent. Whichever way you look at it, these are eye-watering losses that have damaged thousands of investors' savings.

So why have they performed so poorly? One reason is that many UK equity income funds have had significant holdings in UK banks because of the high dividends they offer, says Andy Gadd, head of research at Lighthouse Group.

"These funds have therefore been hit hard by the impact on UK banks of the ongoing US sub-prime lending crisis," he says. "In contrast, the sectors which have performed best contain companies that pay hardly any income, such as mining stocks."

It means that income managers have been forced to avoid the best performing companies so they can hit their income target. At the same time they are backing those which, although they are still paying dividends, are under-performing. However, that doesn't mean they should be dismissed, argues Schooling. "Equity income funds have had a tough time, but income is always welcome as far as investors are concerned."

The secret for investors, according to John Chatfeild-Roberts, author of Fundology: the secrets of successful fund investing, and head of Jupiter's award-winning fund of funds team, is to choose their high-yield investments very carefully. "Investing for yield is perfectly sensible at this stage of the cycle but you need to be careful about what it is you are buying and whether that yield is sustainable," he says. "There are a lot of factors that investors will need to keep an eye on."

An example, he says, is in the banking sector. You need to ask yourself: how are the banks performing? Are they going to keep their dividends at the current level? What is the likelihood of a rights issue being announced in the coming months?

Are there any other ways investors can protect themselves? The best way is through diversification, suggests Gadd. "Pick a range of managers from the UK Equity Income sector that have different styles," he says. "This can include funds that follow a 'traditional' route and those pursuing a 'barbell' approach."

This means that there are two aspects to the portfolio: a large proportion of the investments are there to produce the high income, but a reasonable amount – such as 25 per cent – is invested in companies that are expected to grow quickly.

Penrice suggests that investors should stick to "tried and tested" funds that have performed well through both the good times and the bad. "I would stick with funds such as Invesco Perpetual Income and High Income Funds, as well as Jupiter Income, Rathbone Income and Newton Income," he says. "I also like the PSigma income fund run by the experienced Bill Mott."