With the UK dropping back into recession, the chances of the Bank of England raising its base rate look increasingly remote over the next two years.
This means that anyone hoping to generate a half-decent return on their savings will have to look to investments, rather than savings accounts.
"There has rarely been a time in my investment career where income has been more important," said Kerry Nelson, managing director of Nexus IFA. "I saw it once before after the dot come crash – in low growth markets like we’re seeing at the moment, income makes up the bigger part of investors’ returns."
Traditional fixed interest funds such as the FE five crown-rated M&G Strategic Corporate Bond
or Fidelity Strategic Bond
portfolios, which invest in company and government debt, are the most obvious route to a steady stream of income.
Sectors' annualised returns over 10-yrs
Source: FE Analytics
Bonds that are most at risk of defaulting tend to offer the highest returns. Government bonds are considered the lowest risk, followed by corporates, while high yield or junk bonds are at the other end of the spectrum. These securities, which are BBB-rated or lower, have the highest correlation to equity markets.
The average Sterling Corporate Bond fund has an annualised total return over the last 10 years of 4.03 per cent and an average one-year historic yield of 3.79 per cent. Six funds, including Bryn Jones’ Rathbone Ethical Bond
portfolio, have a yield of more than 5 per cent.
By contrast, the average Sterling High Yield Bond fund has an annualised total return of 6.23 per cent and an average yield of 5.62 per cent. All but five of the 22 funds in the sector have a yield of more than 5 per cent, and two – Aberdeen High Yield Bond
and Marlborough High Yield Fixed Interest
– have a yield of more than 7 per cent.
The benefit of investing in bonds is that they are less risky and volatile than equities. If a company goes bankrupt, debt-holders are prioritised over shareholders and usually get at least some of their money back.
This makes bond funds an ideal haven for someone approaching retirement or who doesn't have a long enough investment horizon to absorb periods of capital depreciation.
The global financial crisis and heightened macroeconomic risks mean that there is currently huge demand for fixed income securities. As a result the yields available on perceived safe-havens such as UK Government bonds have fallen to record low levels and behind inflation.
This is one of the reasons for the current popularity of equity income investment. By holding companies that pay dividends, funds can generate a return for investors in a low-growth environment.
In addition, numerous studies have revealed that reinvesting dividends is a reliable method for achieving growth over the long-term. According to the Barclays Equity Gilt Study, £100 invested in the UK stock market in 1945 would have been worth £4,027 at the end of 2011 with dividends reinvested, or £227 without.
The average UK Equity Income fund has an annualised total return of 4.23 per cent over the last decade, and a yield of 4.43 per cent – both of which are in excess of the average Corporate Bond and Strategic Bond portfolios.
The trouble with the recent popularity of this type of investment is that increased demand means the market now demands a premium for what are deemed high quality stocks – especially against the backdrop of a worsening sovereign debt crisis.
Moreover, a recent FE Trustnet
study highlighted the severe lack of diversity among UK Equity Income funds, which tend to generate most of their dividends from just a handful of FTSE 100 stocks.
As a result, investors are now looking further afield for products to diversify their income sources.
A growing trend for companies domiciled outside the UK to pay dividends has seen the advent of IMA Global Equity Income. Funds in this sector give investors access to a portfolio of international equities which provide a stream of income as well as the possibility for capital growth.
Our data shows that the average fund in the sector has an annualised return of 2.43 per cent over the last 10 years and an average yield of 3.94 per cent.
Despite being an unloved sector with the majority of investors at present, property is also an area where investors can get access to income. Funds buy commercial or industrial business space and pay a yield to investors via the income they receive from rent. There is also the chance for capital appreciation, or loss, when the manager sells the underlying assets.
One criticism of property is that it is an illiquid asset class and managers find it difficult to sell if there is a crisis. This was seen most acutely in 2008, when the average IMA Property fund suffered losses of 30.12 per cent.
Infrastructure is also a possible income play, although there are only a few options in the open- and closed-ended spaces. Six of the seven infrastructure trusts in the AIC universe are currently trading on a premium, such is the popularity of income in the current environment.
Exactly which investment is right for who depends on the investors' circumstances and how long they have to invest.
Nelson commented: "I use equity income strategies to underpin all my portfolios. The story never goes away and is best realised over the long-term."
"Fixed income is particularly valuable for cautious investors or perhaps those approaching retirement. These funds lack the volatility of equities and can be used to give capital protection."