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

PROMOTED VIDEO
Life and Style
Child's play: letting young people roam outdoors directly contradicts the current climate
lifeHow much independence should children have?
Arts and Entertainment
Tycoons' text: Warren Buffett and Bill Gates both cite John Brookes' 'Business Adventures' as their favourite book
booksFind out why America's richest men are reading John Brookes
Arts and Entertainment
<p><strong>2008</strong></p>
<p>Troubled actor Robert Downey Jr cements his comeback from drug problems by bagging the lead role in Iron Man. Two further films follow</p>
filmRobert Downey Jr named Hollywood's highest paid actor for second year running
Life and Style
Dale Bolinger arranged to meet the girl via a fetish website
life
Property
Sign here, please: Magna Carta Island
propertyYours for a cool £4m
Life and Style
tech
News
The Commonwealth flag flies outside Westminster Abbey in central London
news
Arts and Entertainment
Struggling actors who scrape a living working in repertory theatres should get paid a 'living wage', Sir Ian McKellen has claimed
theatre
Extras
indybest
News
Skye McCole Bartusiak's mother said she didn't use drink or drugs
peopleActress was known for role in Mel Gibson film The Patriot
Arts and Entertainment
tvWebsite will allow you to watch all 522 shows on-demand
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

    Training Programme Manager (Learning and Development)-London

    £28000 - £32000 per annum + benefits: Ashdown Group: Training Programme Manage...

    Training/Learning and Development Coordinator -London

    £28000 - £32000 per annum: Ashdown Group: Training/Learning and Development Co...

    Business Anaylst

    £60000 - £75000 per annum + BONUS + BENEFITS: Harrington Starr: Business Anal...

    Project Manager - ETRM/CTRM

    £70000 - £90000 per annum + Job Satisfaction: Harrington Starr: Project Manage...

    Day In a Page

    Some are reformed drug addicts. Some are single mums. All are on benefits. But now these so-called 'scroungers’ are fighting back

    The 'scroungers’ fight back

    The welfare claimants battling to alter stereotypes
    Amazing video shows Nasa 'flame extinguishment experiment' in action

    Fireballs in space

    Amazing video shows Nasa's 'flame extinguishment experiment' in action
    A Bible for billionaires

    A Bible for billionaires

    Find out why America's richest men are reading John Brookes
    Paranoid parenting is on the rise - and our children are suffering because of it

    Paranoid parenting is on the rise

    And our children are suffering because of it
    For sale: Island where the Magna Carta was sealed

    Magna Carta Island goes on sale

    Yours for a cool £4m
    Phone hacking scandal special report: The slide into crime at the 'News of the World'

    The hacker's tale: the slide into crime at the 'News of the World'

    Glenn Mulcaire was jailed for six months for intercepting phone messages. James Hanning tells his story in a new book. This is an extract
    We flinch, but there are degrees of paedophilia

    We flinch, but there are degrees of paedophilia

    Child abusers are not all the same, yet the idea of treating them differently in relation to the severity of their crimes has somehow become controversial
    The truth about conspiracy theories is that some require considering

    The truth about conspiracy theories is that some require considering

    For instance, did Isis kill the Israeli teenagers to trigger a war, asks Patrick Cockburn
    Alistair Carmichael: 'The UK as a whole is greater than the sum of its parts'

    Alistair Carmichael: 'The UK as a whole is greater than the sum of its parts'

    Meet the man who doesn't want to go down in history as the country's last Scottish Secretary
    Legoland Windsor's master model-makers reveal the tricks of their trade (including how to stop the kids wrecking your Eiffel Tower)

    Meet the people who play with Lego for a living

    They are the master builders: Lego's crack team of model-makers, who have just glued down the last of 650,000 bricks as they recreate Paris in Windsor. Susie Mesure goes behind the scenes
    The 20 best days out for the summer holidays: From Spitfires to summer ferry sailings

    20 best days out for the summer holidays

    From summer ferry sailings in Tyne and Wear and adventure days at Bear Grylls Survival Academy to Spitfires at the Imperial War Museum Duxford and bog-snorkelling at the World Alternative Games...
    Open-air theatres: If all the world is a stage, then everyone gets in on the act

    All the wood’s a stage

    Open-air productions are the cue for better box-office receipts, new audiences, more interesting artistic challenges – and a picnic
    Rand Paul is a Republican with an eye on the world

    Rupert Cornwell: A Republican with an eye on the world

    Rand Paul is laying out his presidential stall by taking on his party's disastrous record on foreign policy
    Self-preservation society: Pickles are moving from the side of your plate to become the star dish

    Self-preservation society

    Pickles are moving from the side of your plate to become the star dish
    Generation gap opens a career sinkhole

    Britons live ever longer, but still society persists in glorifying youth

    We are living longer but considered 'past it' younger, the reshuffle suggests. There may be trouble ahead, says DJ Taylor