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