In the search for higher income, corporate bond funds have become increasingly popular. The more conventional funds, investing in the loan stock issued by blue chip companies, will now give a yield of around 6 per cent, while those investing in lower-rated companies, the so-called junk bonds, can pay up to 8 per cent.
While these investments may show some growth over the long term, past history teaches us that they are unlikely to match the growth from ordinary shares.
This is because, if a company issues loan stock that it will repay in full in 2025 with a coupon of 7 per cent, then it will continue to pay holders pounds 7 for every pounds 100 they invest until the loan is paid back. So the prospects of any capital growth is low even if it can be traded.
This is unlike a company's ordinary shares, where the market price depends on a number of factors - the most important of which are its future prospects. The better these are, the more the demand for its shares, and the higher they will rise.
This has led to a revival of the debate in the investment industry about whether there are really irreconcilable differences between income and growth. Could investors looking for either a fixed or rising level of income be better suited investing in growth or low yielding funds? Is it better to go for the highest income commensurate with risk, or to cash in some of the growth available from the fund?
Let us take an extreme example. Over the past year, on an offer-to-bid price basis, with net income reinvested, a pounds 1,000 investment in the CGU PPT Monthly Income fund, one of the most popular corporate bonds, would now be worth around pounds 1,065. The same investment in Jupiter Income, one of the top performing high-yielding funds with a portfolio of ordinary shares, would be worth pounds 1,104 - pounds 39 more.
While the CGU fund is yielding around 6.7 per cent, Jupiter's yield is less than half this at some 3.2 per cent. The investor would, therefore, have benefited from a higher dividend with the former, but much better growth with the latter. If some of this growth had been cashed in, then the investor would have had a better income and still maintained a sizeable holding investment in a fund which was showing greater growth prospects.
Of course, tax has to be taken into consideration. If the investment is a direct one, then if you are taxpayer, income tax is chargeable on the dividends, and you will receive them net of basic rate tax. You are allowed up to pounds 6,800 of your profits free of capital gains tax in the current financial year, rising to pounds 7,100 from 6 April.
If an investment is inside a PEP wrapper, up until now all the growth and income has been tax free. From the new financial year, the PEP manager can only reclaim half the advanced corporation tax that companies pay on their dividends, while the income paid from corporate bonds will still remain tax free. So this will slightly reduce the payment received from ordinary shares. But any profit made from the sale of units will still remain free of capital gains tax.
So the message is a simple one, according to Jason Hollands of BESt Investment who says: "If you need to maximise your income, then you should be choosing corporate bonds, but if you want a mixture of a rising income and capital growth, then there is still a strong case for buying income funds that invest in a range of good quality equities."
Fund managers who invest in ordinary shares are usually looking for growth in both dividends and capital. Colin Morton, who looks after the BWD Rensburg Equity Income Trust, another top performer in the income sector, says: "To get this, we invest between 70 and 80 per cent of the fund in blue chip stocks, such as Glaxo, BP and BT.
"We look for a growing income stream, and these companies have the stated aim of increasing dividends paid out to shareholders. As well as being extremely well managed, they are extremely liquid, which means that we can always trade in them.
"We participate directly in the success of the British economy, and if we invest successfully, as we have in the past, then both the income and the capital of our investors will continue to grow."
So the investor can always supplement the income from a fund, assuming it has grown in value, by cashing in some of their units. If this is done with a corporate bond fund, there is a danger that the value of the original capital investment will be eaten away.
"If you can afford to take a lower level of income, with the prospects of it rising in the future, and of capital gains, then you should look to equity funds," says Paul Penny, of Financial Discount Direct. "You can always supplement income from the growth in the value of the units, and this should probably outstrip the rate of inflation."
Contacts: BESt Investment on 0171 321 0100; BWD Rensburg on 0148 460 2250; Financial Discount Direct on 01420 543727Reuse content