In a low-yielding world in which most savings accounts pay less than 1 per cent interest, an investment offering an income of 7 per cent is tantalising. But, as experienced investors can testify, there is no such thing as a free lunch.
These enticing yields come with higher risks, as our feature on 'enhanced income' funds explains.
So what levels and types of risk should you expect from the alternatives? Money Observer runs the rule over other routes to 7 per cent income, and assess the pros and cons of each.
A high-dividend should be treated with a healthy dose of scepticism. Share prices and yields have an inverse relationship, so a high yield is usually a sign that a stock is out of favour for some reason.
The big danger in buying shares with high dividend yields is that you could end up buying a 'value trap': a share in a company in trouble that is unlikely to keep its income promises.
The table below (click to enlarge) details the 10 highest-yielding shares in the FTSE 350 index, ranked in order of their forecast yield - which is based on analysts' expectations for the year ahead.
Top of the income pile is Carillion, the construction and support services firm. A sky-high yield of 9.3 per cent instantly has alarm bells ringing, but a positive is that the dividend is covered 1.8 times by underlying earnings. A dividend cover score of 2 is viewed as relatively safe.
Investors, however, seem unconvinced. Carillion is today the most heavily shorted UK-listed stock, and this has been the case for a couple of years. Various hedge fund managers are betting that the company's indebtedness will weigh on margins.
More generally, there are also concerns about the outlook for the property market post-Brexit. Indeed, Carillion is not alone: three housebuilders now yield around 7 per cent, Barratt Developments, Taylor Wimpey and Berkeley Homes.
Russ Mould, investment director at broker AJ Bell, makes the point that at the end of February, the share price of Taylor Wimpey 'barely moved' on the day the firm affirmed dividend plans equating to a 7 per cent-plus yield for 2017.
He says: 'Concerns about growth and fears over whether Brexit or high prices or record levels of consumer debt could erode housing demand and leave the big housebuilders on generous yields and low earnings multiples - the lowly valuation is the market's way of saying it doesn't entirely trust the earnings forecasts.'
Elsewhere, other high-yielding dividend shares look vulnerable. International Personal Finance boasts the second-highest forecast yield of 7.6 per cent, but this comes against a backdrop of a depressed share price of late, down 42 per cent over the past three months on the back of declining profit growth.
Two big income heavyweights, in the shape of BP and Royal Dutch Shell, are yielding around 7 per cent.
Given that the oil price collapse reached its nadir in the first quarter of last year and that both the oil majors' management teams have publicly committed to keeping dividends flowing, these two shares are arguably a safer bet than other names in the table.
He adds: 'Businesses that over-distribute are liquidating themselves in order to sustain dividends, and this is what Royal Dutch Shell and BP are doing. Both firms are selling assets and borrowing in order to sustain their dividends.'
Risk-ometer: high risk
It really is a case-by-case scenario, but those who buy a single high-yielding share are taking a gamble on two fronts: they are hoping that dividend promises will be kept and that market sentiment will change towards a stock currently viewed as out of favour.
HIGH-YIELD BOND FUNDS
Whereas bond types such as government bonds have seen their incomes evaporate over the past decade, largely because of central banks' quantitative easing policies, high-yield bonds offer yields today comparable with those available from bonds before the financial crisis.
High-yield bonds are issued by companies regarded as less creditworthy by the credit ratings agencies that therefore have to pay higher rates of interest to compensate investors for the extra risk.
Tom Stevenson, investment director at Fidelity Personal Investing, says: 'By definition, high-yield bond risk rises and falls in line with the wider economy.
'When the economy improves, companies are more secure and able to fund their borrowings; when recession looms, the chances of those companies defaulting rise. So high-yield bonds are anything but dull. Rather, they act like shares on steroids. They behave like equities, and then some.'
Royal London Sterling Extra Yield Bond is one of Money Observer's Rated Funds. Manager Eric Holt manages the fund carefully by running a diversified portfolio of around 200 bonds.
Risk-ometer: medium risk
By picking an experienced high-yield fund manager who knows his or her way around the high-yield market, investors are unlikely to lose their shirts unless the global economy takes a big turn for the worse and falls into recession.
RETAIL BONDS AND MINI-BONDS
Over the past five years or so a swathe of companies has appealed directly to income starved savers. Juicy yields, some of which have been in excess of 7 per cent, have been on the table.
These bonds are targeted at small investors, and they can be bought from as little as £1,000. The far larger corporate bond market is dominated by institutions and comes with much higher minimum investment requirements.
But important distinctions need to be made here. Retail bonds are tradable on the secondary market (via the London Stock Exchange's Order Book for Retail Bonds, Orb), whereas mini-bonds must be held to maturity. In addition, mini-bonds typically raise smaller amounts and are on the whole riskier.
Investing in bonds requires just as much scrutiny of company balance sheets as investing in shares. Look at cash flow, debts and profits, among other things.
Two examples of retail bonds available on the secondary market and yielding exactly 7 per cent are Lloyds TSB Bank (maturing in 2023) and BT (2020).
A mini-bond on the market that offers 7 per cent income is the Regenerate London Bond. The bond issuer says it is seeking to tap into the 'chronic housing shortage' in London.
Investors' money will be used to fund the acquisition of greenfield and brownfield land that will then be sold on to property developers.
Risk-ometer: high risk
Investors are essentially taking a view on whether the issuer will grow as hoped in order to pay the interest payments. If the issuer fails, investors face the prospect of losing all their capital.
Check whether investor protection measures are in place. Protection may take the form of a debenture secured against assets the bond invests in, which is the case with the Regenerate London Bond.
VENTURE CAPITAL TRUSTS
Venture capital trusts (VCTs) do not have a headline yield of 7 per cent, but the upfront income tax relief of 30 per cent they offer turns a 5 per cent yield into one of just over 7 per cent.
The generous tax break effectively lowers the cost of a £10,000 investment to £7,000; £500 of dividends then yields 7.14 per cent when considered as a percentage of £7,000 rather than £10,000.
March is the height of the 'VCT season' when firms bid for investors' money ahead of the tax year end.
Ben Yearsley, investment director at financial adviser Wealth Club, says offers still with reasonable capacity at the time of writing, which he has personally invested in over the years, include:
- Hargreave Hale AIM 1 and 2 VCT - target a dividend of 5 per cent of year-end NAV
- Amati and Amati 2 AIM VCT - target a dividend of 5 per cent of year-end NAV
- Elderstreet VCT - targets a dividend of 4p a share; the current NAV is 70p a share. The gross dividend yield is 5.7 per cent, but the net yield (after the income tax rebate) is 8.1 per cent.
Risk-ometer: medium risk
VCTs are high-risk because they invest in fledgling businesses, but in order to smooth out risk portfolios are diversified by investing in a range of up-and-coming companies.
Figures published by the Association of Investment Companies show that the VCT sector as a whole was up 82 per cent in terms of share price total return over the decade to 31 December 2016.
PEER-TO-PEER AND CROWDFUNDING
Various peer-to-peer (P2P) and bond-based crowdfunding websites tout high returns.
According to Orca, a research consultancy operating in the P2P space, providers currently offering the innovative finance Isa have interest rates ranging from 3.75 per cent (Landbay) to 12 per cent (Landlordinvest).
Iain Niblock, co-founder of Orca, stresses the importance to prospective lenders of assessing how diversified a platform's loan book is when weighing up different providers.
He says: 'Some P2P firms such as Zopa will lend investors' money to a long list of borrowers, which reduces risk.
'"Provision funds" [held by the provider to cover investors in the event of a borrower defaulting] also reduce loan losses and offer a certain level of comfort, although they are paid for by the borrower in the form of a lower interest rate.'
Risk-ometer: medium risk
As a general rule of thumb, the higher the level of interest on offer, the higher the risk of default.
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