Investment: Hidden risk in income funds

That tempting high yield offered may be there only because the fund is investing in junk bonds

ASK ANY financial adviser what their investor clients are looking for and one answer comes back with monotonous regularity. Iincome. In a world of low inflation, the yields on most classes of investment are as low as most people can remember. Whether you look at savings rates, dividend yields or annuity rates, the amount of income an investment produces is minute by historical standards.

Base rates are now at their lowest for more than 20 years. Gilt yields have fallen to levels last seen in the 1960s and the dividend yield on shares, as measured by the FTSE All-Share index is at 2.3 per cent, an all-time low. (Only in the Fifties did investors decide for the first time that shares should yield less than bonds.)

So it is no surprise income funds have started to come into their own. The first corporate bond funds were introduced a few years ago, but they are proving immensely popular. The largest fund management groups, such as Fidelity, Barclays and M&G, are taking in millions from investors for high-income funds that offer what look highly attractive yields in the low inflation climate.

But, as Standard & Poor's Fund Research make clear in their latest review of this important new sector, anyone attracted by a high-income fund needs to look carefully at what they are buying. More than almost any other segment of the fund market, high-income funds invest in a bewilderingly wide range of different types of investment - and it seems a fair bet that many investors are by no means clear about what kind of risks they are taking when they plump for that temptingly high yield.

Thus, out of the 260-plus funds in the UK high-income universe, 15 per cent are pure gilt funds - that is, they invest solely in Government securities. Around 65 per cent invest more broadly in fixed-interest securities of various types, not just gilts, but corporate bonds, convertibles and preference shares. The remaining 20 per cent invest in bonds and high-yielding equities, which makes them a composite bond and equity fund.

The problem for investors is that each of these types of investment have different levels of yield and different risk profiles. All fixed interest securities have one fundamental feature - their value rises and falls in line with the prevailing level of interest rates (interest rates up, prices down; interest rates down, prices up). But that does not mean all funds which own fixed-interest securities are alike.

For a start, a fund's current yield and sensitivity to changes in interest rates can vary dramatically, depending on the type of security they hold. The yield on funds for the UK High Income sector actually ranges from 8 per cent (the highest) to just 2.8 per cent (the lowest). Coincidentally, and perhaps with one eye on the Trades Descriptions Act, the fund with the lowest yield, Perpetual High Income, has always had a high weighting in equities, and changed its policy to put more of its fund into equities. It is reclassifying itself as a equity income fund.

As far as sensitivity to interest rates is concerned, the key measure is the duration of a fund's portfolio. Funds with the same apparent yield might vary markedly in their volatility because, for instance, a bond with a 20-year maturity is far more sensitive to interest rate movements then one which matures in, say, five years. Investors need to be clear how much interest rate risk of this kind they are taking on.

Yet another source of differentiation is the credit quality of the securities high-income funds are buying. By definition, Government securities are the best credit risk, followed by the best corporate bonds and so on down the credit rating scale. Since nothing comes free in investment, the lower the credit rating, the higher the return the market requires, which means, for bond fund investors, that tempting high yield you are being offered may be there only because the fund is investing in junk bonds.

In chasing higher yields, investors are invariably taking on a higher degree of risk, not necessarily a bad thing, provided they are happy with what is involved. The past 18 months have demonstrated the attractions and the risks of high-income funds. The 12-month period to the start of June this year was unusual, gilts outperforming shares by a comfortable margin. But because of the impact of the Russia and hedge fund crises last autumn, which resulted in a so-called "flight to quality", unusually gilts also performed better than fixed-interest securities of lower credit quality. As the graph shows, the difference in corporate bond and gilt yields widened dramatically the further down the credit rating league tables you went.

This was either evidence of the added risk investors take when they pursue higher yields, or a buying opportunity for anyone who thought the market reaction to crisis was overdone. Some of the best-performing income funds this year have been those which bought the highest- yielding corporate bonds at that stage. Because the corporate bond market is relatively young here, the markets for them are not very liquid and it is difficult to realise the value of a fixed interest portfolio as quickly as fund managers would like. This happened with funds investing in preference shares and convertibles.

The message for investors who are attracted by high-income funds is this - look carefully at what the funds you are buying are trying to do, because there is a world of difference between a gilt fund and a junk bond fund. Look carefully at performance records, bearing in mind that income may be achieved at the expense of capital growth. If in doubt, go for a fund with a good name and a consistent track record. The table lists five funds that secured high ratings from Fund Research - only two funds have a AAA rating, and one of those is Perpetual High Income which is moving over to the equity income sector.

Finally, remember all high-income funds, just like equity funds, have charges and costs. Study those carefully. Many funds of this type are charging the same high-bid offer spreads and annual management fees as equity funds, though their returns over time will inevitably be lower. Just as with equity funds, you will be surprised how few funds actually beat even their index over time. Unlike the United States, where low-cost bond index funds are popular, over here no such funds exist. Investors seem happy to pay through the nose for higher yields.

Yet with the equity markets at present levels, and investment yields so low, bond funds - whether you choose to call them high income funds or not - will continue to grow. They are an important addition to the investor's armoury. But, like guns, they must be handled with care.

davisbiz@aol.com

Travel
travel
Arts and Entertainment
The cast of The Big Bang Theory in a still from the show
tvBig Bang Theory filming delayed by contract dispute over actors' pay
Sport
England celebrate a wicket for Moeen Ali
sportMoeen Ali stars with five wickets as Cook's men level India series
News
Morrissey pictured in 2013
people
PROMOTED VIDEO
Voices
A family sit and enjoy a quiet train journey
voicesForcing us to overhear dull phone conversations is an offensive act, says Simon Kelner
News
peopleGuitarist, who played with Aerosmith, Lou Reed and Alice Cooper among others, was 71
Travel
travel
News
Robyn Lawley
people
News
people
News
i100  ... he was into holy war way before it was on trend
News
ebookA unique anthology of reporting and analysis of a crucial period of history
Arts and Entertainment
High-flyer: Chris Pratt in 'Guardians of the Galaxy'
filmThe film is surprisingly witty, but could do with taking itself more seriously, says Geoffrey Macnab
News
people
Life and Style
food + drinkVegetarians enjoy food as much as anyone else, writes Susan Elkin
Life and Style
lifeDon't get caught up on climaxing
Life and Style
tech
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.

iJobs Job Widget
iJobs Money & Business

1st Line Support Technician / Application Support

£20000 - £24000 per annum: Harrington Starr: A leading provider of web based m...

Team Secretary - (Client Development/Sales Team) - Wimbledon

£28000 - £32000 per annum: Ashdown Group: Secretary (Sales Team Support) - Mat...

Accountant / Assistant Management Accountant

Competitive (DOE): Guru Careers: We are looking for an Assistant Management Ac...

Senior Investment Accounting Change Manager

£600 - £700 per day + competitive: Orgtel: Senior Investment Accounting Change...

Day In a Page

Save the tiger: The day America’s love of backyard tigers led to a horrific bloodbath

The day America’s love of backyard tigers led to a horrific bloodbath

With only six per cent of the US population of these amazing big cats held in zoos, the Zanesville incident in 2011 was inevitable
Samuel Beckett's biographer reveals secrets of the writer's time as a French Resistance spy

How Samuel Beckett became a French Resistance spy

As this year's Samuel Beckett festival opens in Enniskillen, James Knowlson, recalls how the Irish writer risked his life for liberty and narrowly escaped capture by the Gestapo
We will remember them: relatives still honour those who fought in the Great War

We will remember them

Relatives still honour those who fought in the Great War
Star Wars Episode VII is being shot on film - and now Kodak is launching a last-ditch bid to keep celluloid alive

Kodak's last-ditch bid to keep celluloid alive

Director J J Abrams and a few digital refuseniks shoot movies on film. Simon Usborne wonders what the fuss is about
Once stilted and melodramatic, Hollywood is giving acting in video games a makeover

Acting in video games gets a makeover

David Crookes meets two of the genre's most popular voices
Could our smartphones soon be diagnosing diseases via Health Kit and Google Fit?

Could smartphones soon be diagnosing diseases?

Health Kit and Google Fit have been described as "the beginning of a health revolution"
Ryanair has turned on the 'charm offensive' but can we learn to love the cut-price carrier again?

Can we learn to love Ryanair again?

Four recent travellers give their verdicts on the carrier's improved customer service
Billionaire founder of Spanx launches range of jeans that offers

Spanx launches range of jeans

The jeans come in two styles, multiple cuts and three washes and will go on sale in the UK in October
10 best over-ear headphones

Aural pleasure: 10 best over-ear headphones

Listen to your favourite tracks with this selection, offering everything from lambskin earmuffs to stainless steel
Commonwealth Games 2014: David Millar ready to serve up gold for his beloved Scotland in the end

Commonwealth Games

David Millar ready to serve up gold for his beloved Scotland in the end
UCI Mountain Bike World Cup 2014: Downhill all the way to the top for the Atherton siblings

UCI Mountain Bike World Cup

Downhill all the way to the top for the Atherton siblings
Save the tiger: The animals bred for bones on China’s tiger farms

The animals bred for bones on China’s tiger farms

The big cats kept in captivity to perform for paying audiences and then, when dead, their bodies used to fortify wine
A former custard factory, a Midlands bog and a Leeds cemetery all included in top 50 hidden spots in the UK

A former custard factory, a Midlands bog and a Leeds cemetery

Introducing the top 50 hidden spots in Britain
Ebola epidemic: Plagued by fear

Ebola epidemic: Plagued by fear

How a disease that has claimed fewer than 2,000 victims in its history has earned a place in the darkest corner of the public's imagination
Chris Pratt: From 'Parks and Recreation' to 'Guardians of the Galaxy'

From 'Parks and Recreation' to 'Guardians of the Galaxy'

He was homeless in Hawaii when he got his big break. Now the comic actor Chris Pratt is Hollywood's new favourite action star