Strip away the City-speak and it's really just an IOU

For those who want a growing level of income and aren't too bothered by capital growth, bond funds may be the answer

We Brits have historically been fans of share dividends and as a result enthusiasts for "equity income funds". These are funds which invest in shares with an eye on capital growth but also the regular distribution of income.

We Brits have historically been fans of share dividends and as a result enthusiasts for "equity income funds". These are funds which invest in shares with an eye on capital growth but also the regular distribution of income.

But in recent years there has been a tendency for companies to reinvest their profits rather than distribute them as dividends, which has meant the equity market has only provided a modest level of income. The FTSE All Share Index currently has a yield of around a measly 2.1 per cent.

Of course, shares still offer strong potential for capital growth. If you want a growing level of income year after year and you aren't too bothered by capital growth, the world of equity income funds is being fast eclipsed by bond funds.

Bonds are in effect "IOUs" issued by companies when they want to borrow money. They are a loan which will be paid back after a pre-determined period of time, during which they pay the bondholders a fixed level of income. Hence bonds are often referred to in City-speak as "fixed income securities".

While the level of income on a bond is fixed, the capital value of the bond may rise or fall as it is traded on the stockmarket. There is a simple rule to remember with bonds: when interest rates rise, bond capital values fall, and vice versa. Funds investing in bonds come in two basic categories: those that invest in low risk bonds issued by financially strong companies, and those that invest in "high yield" bonds.

The risk with any bond is that the company issuing the bonds "defaults", in other words is unable to pay the loan back at the end of the bond's life. Mainstream bond funds try and minimise this risk by focusing on well established, financially strong companies who receive good credit ratings from independent agencies such as Moody's or Standard & Poor's. The current yields on these funds, after charges, is around 6.5 per cent.

High yield bonds are those issued by companies who do not have strong credit ratings and therefore have a greater risk of default. The good news is that they will have to compensate for this extra risk by offering much higher rates of interest than mainstream "investment grade" bonds. High yield bond funds are currently boasting rates of around 8 per cent. As a general rule when you are looking at bond funds, the higher the level of income, the higher the risk of the portfolio. But be warned. A fund that advertises a higher level of income may also be taking its management charges out of the bond's capital.

This is important. When a bond matures it simply pays back the capital originally raised. Bond fund managers can only grow the capital value of a fund if they engage in some clever buying and selling when bonds slip below the price they'll pay at maturity. The prospects for capital growth are therefore limited. For this reason, it is better if bond funds deduct their annual charges from income rather than the capital lest this is eroded each year. In general, investors should be sceptical of funds that take their annual charges from the capital value of the fund.

Another thing to be wary of is that the income yields blasted over the marketing literature can differ from what you will actually receive. In the past the published yield has often not taken account of the impact of the fund's charges and has usually been the "running yield" rather than the "gross redemption yield". While the running yield is simply the average rate of interest on the portfolio, the gross redemption yield takes account of any likely capital loss built into the portfolio. For instance, if bond prices are currently higher than the value they will mature at you will experience a capital loss: the gross redemption yield takes account of this.

Thankfully, the Association of Unit Trust Investment Funds (AUTIF) has now instituted a code of conduct covering the marketing of bond funds, so that the yields in marketing literature must display the gross redemption yield after charges. This is a long overdue move which should enable investors to more clearly see the return they'll actually receive rather than the notional "running yield" on the underlying portfolio.

The writer is deputy managing director of independent financial advisers BEST Investment. A free copy of its recommendations is available on 020-7321 0600

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

PROMOTED VIDEO
Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Recruitment Genius: Software Development Manager

    £40000 - £50000 per annum: Recruitment Genius: This is an exciting opportunity...

    Ashdown Group: Product Manager - (Product Marketing, Financial Services)

    £30000 - £35000 per annum + Benefits: Ashdown Group: Marketing Manager - Marke...

    Recruitment Genius: Compliance Assistant

    £13000 per annum: Recruitment Genius: This Pension Specialist was established ...

    Ashdown Group: Market Research Executive

    £23000 - £26000 per annum + Benefits: Ashdown Group: Market Research Executive...

    Day In a Page

    Isis hostage crisis: The prisoner swap has only one purpose for the militants - recognition its Islamic State exists and that foreign nations acknowledge its power

    Isis hostage crisis

    The prisoner swap has only one purpose for the militants - recognition its Islamic State exists and that foreign nations acknowledge its power, says Robert Fisk
    Missing salvage expert who found $50m of sunken treasure before disappearing, tracked down at last

    The runaway buccaneers and the ship full of gold

    Salvage expert Tommy Thompson found sunken treasure worth millions. Then he vanished... until now
    Homeless Veterans appeal: ‘If you’re hard on the world you are hard on yourself’

    Homeless Veterans appeal: ‘If you’re hard on the world you are hard on yourself’

    Maverick artist Grayson Perry backs our campaign
    Assisted Dying Bill: I want to be able to decide about my own death - I want to have control of my life

    Assisted Dying Bill: 'I want control of my life'

    This week the Assisted Dying Bill is debated in the Lords. Virginia Ironside, who has already made plans for her own self-deliverance, argues that it's time we allowed people a humane, compassionate death
    Move over, kale - cabbage is the new rising star

    Cabbage is king again

    Sophie Morris banishes thoughts of soggy school dinners and turns over a new leaf
    11 best winter skin treats

    Give your moisturiser a helping hand: 11 best winter skin treats

    Get an extra boost of nourishment from one of these hard-working products
    Paul Scholes column: The more Jose Mourinho attempts to influence match officials, the more they are likely to ignore him

    Paul Scholes column

    The more Jose Mourinho attempts to influence match officials, the more they are likely to ignore him
    Frank Warren column: No cigar, but pots of money: here come the Cubans

    Frank Warren's Ringside

    No cigar, but pots of money: here come the Cubans
    Isis hostage crisis: Militant group stands strong as its numerous enemies fail to find a common plan to defeat it

    Isis stands strong as its numerous enemies fail to find a common plan to defeat it

    The jihadis are being squeezed militarily and economically, but there is no sign of an implosion, says Patrick Cockburn
    Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action

    Virtual reality: Seeing is believing

    Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action
    Homeless Veterans appeal: MP says Coalition ‘not doing enough’

    Homeless Veterans appeal

    MP says Coalition ‘not doing enough’ to help
    Larry David, Steve Coogan and other comedians share stories of depression in new documentary

    Comedians share stories of depression

    The director of the new documentary, Kevin Pollak, tells Jessica Barrett how he got them to talk
    Has The Archers lost the plot with it's spicy storylines?

    Has The Archers lost the plot?

    A growing number of listeners are voicing their discontent over the rural soap's spicy storylines; so loudly that even the BBC's director-general seems worried, says Simon Kelner
    English Heritage adds 14 post-war office buildings to its protected lists

    14 office buildings added to protected lists

    Christopher Beanland explores the underrated appeal of these palaces of pen-pushing
    Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

    Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

    Scientists unearthed the cranial fragments from Manot Cave in West Galilee