Interactive Investor

Five ways to find sky-high investment income of 7%-plus

5th April 2017 10:17

Kyle Caldwell from interactive investor

In a low-yielding world in which most savings accounts pay less than 1% interest, an investment offering an income of 7% 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? Our sister website Money Observer runs the rule over other routes to 7% income, and assess the pros and cons of each.

Individual shares

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 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% 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%, Barratt Developments,Taylor Wimpey and Berkeley Homes.

Elsewhere, other high-yielding dividend shares look vulnerable. International Personal Finance boasts the second-highest forecast yield of 7.6%, but this comes against a backdrop of a depressed share price of late, down 42% 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%.

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.

But not everyone has been persuaded. Respected investor Neil Woodford says both businesses are 'over-distributing' and may well pay the price for doing so.

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."

Funds yielding around 7% include JPM Global High Yield Bond (7.3%), Royal London Sterling Extra Yield Bond (7.2%) and Baillie Gifford Emerging Markets Bond (6.5%).

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%, 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.

How to invest in bonds: a beginner's guide

Two examples of retail bonds available on the secondary market and yielding exactly 7% are Lloyds TSB Bank (maturing in 2023) and BT (2020).

A mini-bond on the market that offers 7% 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%, but the upfront income tax relief of 30% they offer turns a 5% yield into one of just over 7%.

The generous tax break effectively lowers the cost of a £10,000 investment to £7,000; £500 of dividends then yields 7.14% 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.

Where should venture capital trust investors look in 2017?

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% of year-end NAV

Amati and Amati 2 AIM VCT - target a dividend of 5% 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%, but the net yield (after the income tax rebate) is 8.1%.

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% 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% (Landbay) to 12% (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.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

This article was originally published in our sister magazine Money Observer, which ceased publication in August 2020.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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