Money may not grow on trees, but stashing your cash in a tax-efficient Isa can generate handsome income. Helen Pridham explores different products that can help maximise returns.

Everyone’s income is under pressure at present. Low interest rates and rising inflation are squeezing budgets, so the last thing savers need right now is to have their returns reduced further by taxation, especially when those savings have come out of taxed income in the first place. It therefore makes sense to stash as much as possible in an Isa.

Isas are a tax-efficient way of generating income. Interest earned on cash deposits and bonds held within them is tax-free, and there is no further tax to pay on share dividends. They are not subject to higher-rate tax, and a major advantage for retired investors is that the income from Isas does not impinge on their age-related allowance (the higher personal tax-free allowance available to people aged over 65), as it is not considered part of taxable income. Any withdrawal of capital from Isas is also tax-free.

There are several types of asset that can be used to boost income, and it is advisable to have a mix. Cash Isas are a good base, but with low interest rates, the returns they produce are relatively poor.

Higher returns can be obtained from bonds, higher-yielding shares and property, which can all be held within stocks and shares Isas, though they do involve more risk to capital. The best approach is to spread your investments across several asset classes so that your portfolio is balanced.   

Bonds

Bonds, which are issued by companies and governments when they need to borrow money from investors, are a good source of income. They pay out regular fixed interest. Capital is returned to the bondholder at maturity, but in the meantime they can be traded on the stock market. A low-risk way to invest in bonds is through investment funds holding a range of bonds. These funds are currently offering income yields of up to 5 per cent, or even more.

Corporate bond funds have been very popular with investors over the past two years. Their yields looked particularly attractive at the height of the global financial crisis, as the price of bonds had fallen. Increasing demand for bonds since then pushed prices up, so early investors also benefited from capital gains.  Now, however, they have returned to their traditional role as income providers, says Brian Dennehy of independent financial advisers Dennehy Weller. ‘Capital returns are long gone, but bond funds are still attractive if you want a regular income and relatively low capital volatility.’

For investors who want to keep risk to a minimum, Dennehy recommends Fidelity Moneybuilder Income, paying 4 per cent, which invests in high-quality bonds and is a safety-first, low-volatility fund. At the other end of the spectrum, he suggests funds such as Aegon High Yield Bond and Schroder High Income Monthly, yielding 6.6 and 7.9 per cent respectively. Dennehy says: ‘These funds invest in lower-rated bonds, which involve more risk, but these bonds are looking good value at present, so investors could enjoy not just a decent income but also some capital growth from the funds.’

Property

Rents from property are another traditional source of income, and funds investing in commercial property, such as offices and shops, were heavily promoted to Isa investors five years ago. But in 2008 and 2009, the bottom fell out of the commercial property market as the global financial crisis took hold and the sector lost value. Property funds have recovered somewhat over the past year but the income yields of open-ended funds are modest, currently averaging 2.6 per cent.

Most advisers are not recommending property investment funds at present, in case further economic uncertainties cause forced selling. Nevertheless, Nick Scarett of Fair Investment says: ‘We still include a property fund, SWIP Property, in our recommended income portfolio for diversification. But investors have to be in there for the long term.’

Property investment trusts have higher yields and Simon Elliott of Winterflood Securities believes those with high quality portfolios will do best. He says ING UK Real Estate Income, yielding 7.6 per cent, currently offers good value, pointing out that its dividend is fully covered by its rental income.

Bond and property income tips

*Source: Morningstar, figures to 1 February 2011 

Equities

For long-term income investors, share dividends have been one of the best forms of income, but in the past equity income has often meant settling for a lower return to start with. At present, however, yields on shares are looking particularly attractive compared to other asset classes, with the average yield on FTSE 100 companies standing at over 3 per cent. Naturally, there is more risk to capital when you invest your Isa in shares, but over the long term share dividends tend to rise and short-term share price fluctuations can be ridden out.

However, dividends are not guaranteed, as was illustrated by BP’s decision to cancel its dividend last year, and the drying up of bank dividends two years ago. But prospects for dividends going forward are bright. Jonathan Jackson, head of equities at stockbroker Killik, says: ‘Companies have been cost-cutting and now have strong balance sheets generating cash, which is being paid out in dividends. We believe there will be positive surprises in terms of dividend growth this year. The consensus is for growth in excess of 15 per cent.’ Another important reason for Isa income-seekers to consider equity investment is the protection it can give against inflation. If you have a fixed income, its real value will be eroded as the cost of living rises. Dividends, however, tend to rise with inflation as companies can increase their prices accordingly.

To invest your Isa in equities, you can buy shares either individually or via an investment fund or investment trust.

Individual shares

The best companies to buy for protection against inflation are those with pricing power, says Elaine Coverley, equity analyst at stockbroker Brewin Dolphin. Utilities are an obvious example, she adds. 

She particularly likes National Grid and Pennon. ‘National Grid has one of the highest dividend yields, currently 6.8 per cent, and it is targeting 8 per cent a year dividend growth to 2012. The company has stepped up its capital investment and we believe this will drive attractive future earnings growth,’ she says. ‘Pennon has a lower yield, but it is growing dividends rapidly. It gets a steady income from its water business, South West Water, plus high earnings growth from its waste business, Viridor.’

Jeremy Batstone-Carr, director of private client research at stockbroker Charles Stanley, believes pharmaceutical and telecoms companies are good bets for income seekers. He recommends AstraZeneca, yielding 5.3 per cent. He says: ‘The pharmaceuticals sector has performed poorly, but companies have vast amounts of cash which they are giving back to shareholders in dividends. AstraZeneca doesn’t seem able to do anything right and has huge off-patent problems, but the bad news is already in its price and it will pay nice dividends.’   

Jackson at Killik agrees that utilities and pharmaceuticals are good for dividends; he also favours oil companies. His recommendations are GlaxoSmithKline and Compass, yielding 5.2 and 3 per cent respectively. He says: ‘Glaxo has a strong balance sheet, it has been cost-cutting and it is diversifying into consumer healthcare. It has several new products in the pipeline so the future looks relatively bright. What I like about Compass, a contract catering company, is that it is winning lots of new contracts and expanding its margins. It is pushing up its dividends faster than others.’

Shares tipped for income

Source: Thompson Datastream

Investment funds

The advantage of investing in funds rather than individual shares is that you get a wider spread of risk. Funds hold portfolios of high-yielding shares, so if one company has problems with its dividends, your income will not be wiped out.  

An even greater spread of risk is offered by Jupiter Merlin Income, a fund of income funds favoured by Jeffrey Deans, managing director of IFA Save & Invest in Glasgow. Though it has a low starting yield, currently only 2.8 per cent, he maintains: ‘This fund provides a good illustration of the long-term benefits you can get from income funds. Since it was established 18 years ago, investors have got back more than they invested in terms of income, and their capital has also risen in value.’

Deans also picks Schroder Income Maximiser, targeting a yield of 7 per cent. ‘This is a good fund for investors who need a high immediate income and do not mind sacrificing some capital growth. It invests in income stocks with a yield of 3.5 per cent and then doubles it by selling options. This has proved very successful.’

Nick Scarrett, head of pensions and investment at IFA Fair Investment, likes Invesco Perpetual Income, managed by Neil Woodford. ‘He sticks to his guns, and his funds just keep plodding on, delivering good value for investors.’ Andrew Merrick, investment director at IFA Skerritts Wealth Management, looks further afield to Asian equity funds. ‘One such fund that we like is Newton Asian Income,’ he says. 

Investment trusts

Investment trusts also invest in portfolios of shares. Many have progressive income policies and some specifically aim to grow their income payouts at least in line with inflation (see box page 25). Some trusts have managed to increase their dividends every year for the past 20 years or more. Investment trusts can often be bought at a discount, which means you effectively get a higher yield on your investment than if you had bought the same shares yourself at full price.

For his income pick, Simon Elliott of Winterflood Securities recommends Invesco Perpetual Income & Growth, managed by Mark Barnett and yielding 4.6 per cent. The trust has a large-cap bias and is predominantly positioned within defensive sectors such as pharmaceuticals, utilities and tobacco. However, it can go anywhere, and he believes it has the potential to produce attractive returns over the long term.

Andrew Merrick’s favourite is Temple Bar, yielding 4.4 per cent, managed by Alistair Mundy. He explains: ‘It invests in medium to large companies with higher-than-average yields and good asset backing. Mundy takes a contrarian approach with an eye to growing the trust’s income and it has increased its dividends annually for the past 26 years.’

For those who want maximum income, Stuart Jeffries, director of Cerberus Financial Planning, suggests considering trusts such as City Merchants High Yield and Henderson High Income. Both yield over 7 per cent. But he warns that while they pay a high income, there is also a significant risk of capital loss over the medium term, so they are not for risk-averse investors.

How investment trusts can grow their income through thick and thin

Investment trusts have a distinct advantage over investment funds when it comes to providing investors with income. While funds have to pay out all the income they receive each year, investment trusts can retain up to 15 per cent and use it to smooth out their own dividend payments.   This means they can hold money back in good years to make up for shortfalls in the bad. That helped investment trusts to weather the storm when banks stopped paying dividends in 2008, and when BP cut its dividend in 2010, and has enabled many trusts to continue increasing dividends for more than two decades.  Most of the investment trusts in the UK income growth sector have revenue reserves equivalent to at least one year’s aggregate dividend. As such,even if none of their shareholdings paid dividends for a year, the trusts could maintain their payouts.

Investment Trusts with the longest record of dividend increases

Source: AIC

Funds and trusts tipped for equity income

 *Sources: Morningstar, Lipper, figures to 1 February 2011

Contacts

Brewin Dolphin www.brewin.co.uk
Cerberus Financial Planning www.cerberusfp.co.uk 
Charles Stanley www.charles-stanley.co.uk 
Dennehy Weller www.dwcifa.com
Fair Investment www.fairinvestment.co.uk
Killik & Co www.killik.com
Save & Invest www.saveandinvest.com
Skerritts Wealth Management www.scwealthmanagement.co.uk
Winterflood Securities www.wins.co.uk