Investing for income: Don't be dazzled by the gold rush

Investors rushing to buy corporate bonds, whether in a personal equity plan or not, could be making a big mistake. While they certainly offer a high and reasonably risk-free level of income distribution, the prospects are that this will be unlikely to progressively rise over time. Nor is the investment likely to show much in the way of capital growth.

"If you want to maximise your income, then choose corporate bonds," says Jason Hollands of BEST Investment, "but if you want a mixture of a rising income and capital growth, then there is still a strong case for buying income funds that invest in good quality equities."

The yield from low-risk corporate bond funds is now around 6 to 8 per cent. But it is important to realise that the investment is in a fixed- interest fund that usually has a portfolio of various types of corporate loans and, maybe, some government gilt-edged stock. While these loans are traded, their value is usually determined by the quality of the company that issues them and the fixed income they distribute.

If a company issues loan stock that it will repay in full in 2025 with a coupon of 7 per cent, then it will continue to pay holders pounds 7 for every pounds 100 they invest until the date the loan is paid back. So the prospects of any capital growth is minimal even if the loan stock can be traded.

This is unlike equities, where the value of a company's shares depends on a number of factors, the most important being its future prospects. The better a company's profits, the more it is likely to pay shareholders an income in the form of dividends. The better its prospects, the more the demand for its shares, and the higher they will rise.

"Our aim is a growing income stream," says Colin Morton, fund manager of the BWD Rensburg Equity Income Trust, one of the best performers in its sector. "We participate directly in the success of the British economy, and if we invest successfully, as we have, then income for investors will grow."

You will not immediately get a high return from an income fund. Today, these are yielding in the main between 3.5 and 5 per cent, before tax. If they are in a PEP wrapper, the income will be tax-free but only until 5 April, the end of this financial year. This is thanks to last year's Budget.

Up until now, PEP managers could reclaim the advanced corporation tax, the tax a company pays on the dividends it distributes, on behalf of their investors. After 5 April, and for the next five years, they will only be able to reclaim half. After April 2004, they will not be able to reclaim any ACT.

This means that if you received pounds 125 in dividends from your PEP, of which pounds 25 was reclaimed ACT, and assuming no increase in the cash pay-out, the amount will drop to pounds 111 in the coming financial year, and to pounds 100 after 2004. Corporate bonds, however, will still pay out tax-free income as they do not invest in shares.

But of course, income-fund managers are looking for growth in both dividends and capital. "We invest between 70 and 80 per cent of the fund in blue- chip stocks such as Glaxo, BP and BT, all of which are in the FTSE 100 index," says Colin Morton. "These have the stated aim of increasing dividends paid out to shareholders. As well as being extremely well managed, they are extremely liquid, which means that we can always trade in them."

The income-fund managers hope to increase the income paid to investors by more than the rate of inflation. This is unlike the income from a corporate bond which is fixed, and will therefore be reduced in value by the rate of inflation.

If you need to supplement your income from a fund, then assuming that they have grown in value, you can always cash in some of your units. "If you hold the units in a PEP, then you won't have to pay capital- gains tax," says Kim North of Pretty Financial, a London-based independent financial adviser. "If they are held direct, then you need to have made over pounds 6,800 in capital gains in the year before any tax is payable." Less than 7,000 investors in the London area paid any capital-gains tax last year.

"If you can afford to take a lower income, with the prospects of it rising in the future and of capital gains, then you should look to equity income funds," says Paul Penny, of Financial Discount Direct. "You can supplement income from the growth in the value of the units, and this should outstrip the rate of inflation.

BEST Investment 0171-321 0100; BWD Rensburg 0148 460 2250; Pretty Financial 0171-377 5754; Financial Discount Direct 01420 549090