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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.