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Five funds yielding 6% plus

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You should never buy an investment because of yield alone. However, if you are prepared to tolerate the risks, Charles Stanley’s Rob Morgan identifies five high-yielding funds that could help boost income from your portfolio.

Investors are naturally attracted to investments producing a high level of income. However, it is also a warning sign. There is likely to be a very good reason why an investment yields so much. If it is a share there could well be expectations of a dividend cut.

For bonds, higher yield means higher risk, and more chance of default and capital loss. However, there are funds designed to produce high levels of income while aiming to control these risks through diversification, and sometimes through more sophisticated techniques including the use of derivatives.

Funds yielding over 6% annually presently fall into two main camps: Those investing in high yield bonds, and those investing in equities while employing a technique involving “covered call” options.

The first group, high yield bond funds, invest in companies, countries or other entities whose credit rating is lower, and perceived risk of default is higher, than so-called “investment grade” bonds. This means there is more chance investors do not receive the income from the bond and/or the return of capital at the end of the bond’s life – usually due to insolvency. Funds investing in this area usually have diverse portfolios with hundreds of underlying investments, but there are still significant risks.

The second group of funds invest in dividend-paying shares and enhance the yield through a “call option” strategy written over parts of the portfolio. This means selling contracts that oblige the fund to sell certain underlying shareholdings to a buyer at a pre-determined price – if and when the share price rises to a certain level.

Harvesting call option “premiums” in this way boosts the income paid to fund investors, but it comes at a price. Capital gains on shareholdings are capped but losses are not, and forfeiting upside potential means over the long term you would expect this strategy to underperform. However, there is scope for it to outperform during periods of falling or sideways markets.

You should never buy an investment because of its yield alone but if your portfolio could do with a yield boost, and you are prepared to tolerate the risks involved, the five funds below could be worth considering. All yields are variable and not guaranteed.

Fidelity Enhanced Income – 6.9%

This fund aims to deliver a high and regular income with a target yield of 150-200% of the prevailing yield on the FTSE All-Share Index, enhanced by the writing of call options. Investing primarily in UK companies, portfolio manager Michael Clark believes companies that deliver consistent dividend growth also deliver the strongest returns over the medium to long term. He also seeks ‘safety of income at reasonable price’ focussing his attention on companies with the ability to grow their dividend over time. For those investors concerned primarily about income generation and preservation of capital rather than growth potential, we believe this is a sensibly constructed portfolio.

Investec Emerging Markets Blended Debt – 6.2%

Some of the highest bond yields can be found in emerging markets. Clearly this is for a reason: overall there is more chance of non-payment or default than in more established economies, plus there are other risks such as political instability and large fluctuations in currency values. However, there is opportunity too, not least owing to the sheer variety of fixed income securities on offer. Investors can choose between debt issued by countries or by companies, as well as local currency debt and so-called “hard” currency debt, which represents borrowings in US dollars. More mature and stable nations such Mexico offer higher credit ratings but relatively low yields, while in countries with higher credit risks such as Argentina and Venezuela higher yields can be found – but with higher risks.

This fund invests across the whole spectrum of emerging market debt. We believe its blended approach combining asset allocation across local currency bonds, hard currency bonds, corporate bonds and currency markets, together with aiming to pinpoint the best company or country-specific opportunities within these categories, should provide the potential for superior long term returns. We regard Investec’s emerging market debt team as one of the most stable, well-resourced and experienced in the peer group, and one to watch in this specialist area.

Royal London Sterling Extra Yield Bond – 7.2%

Manager Eric Holt casts a wide net to find the best opportunities in high yield bonds, and invests predominantly in the UK. Rather than build a portfolio of bonds that have received a credit rating from an agency such as Moody’s, he also invests in “unrated” bonds, which most investors ignore perceiving them to be higher risk or not worth the effort of looking into. However, many companies choose not to be rated as agencies charge a fee to classify their debt, providing the opportunity for the Royal London team to conduct their own research to uncover bonds they believe are high quality while offering attractive yields. A willingness to look for opportunities in areas where others are reluctant to tread leads to a distinctive portfolio, so the fund could be of interest to those wishing to diversify a fixed income portfolio.

RWC Enhanced Income – 7.0%

Portfolio managers Ian Lance, Nick Purves and John Teahan aim to protect and grow the real value of investors’ capital whilst delivering a constant annual yield of 7% by investing in a portfolio of strong, but lowly-valued businesses predominantly listed in the UK. They adopt a contrarian approach, typically purchasing shares that are out of favour, and which they believe are undervalued relative to their “intrinsic” value. They also enhance the income of the portfolio through writing call options. The managers are presently cautious about the build-up of debt in the global economy, particularly among companies where earnings that support debt could be under pressure. This concern extends beyond the energy and commodities sectors into other areas. Given their outlook, the managers favour large, stable businesses in less economically-sensitive areas, while avoiding financial leverage, incorporating pension liabilities and long term property leases as well as debt.

Schroder Asian Income Maximiser – 7.0%

Asia is home to many dividend-paying shares and this fund combines an equity income approach to investing in the region with a call option strategy to boost the fund’s yield. The target yield is 7%, the highest of any fund in the Asian peer group. We believe the level of resource and experience of the Schroders Asian team is impressive. Manager Richard Sennitt works closely alongside Matthew Dobbs in London and is able to leverage ideas from the wider team based in Singapore, headed by Robin Parbrook. For investors wishing to diversify an income portfolio with the addition of Asian equities this represents an interesting option, although some growth potential is given up in exchange for higher yield meaning it will likely lag conventional Asian equity funds in strong market periods.

Rob Morgan is pensions & investments analyst at Charles Stanley