When rates go up, try a little bit of juggling

With interest rates set to rise further in coming months, investors seeking income from their savings should find more opportunities out there.

With interest rates set to rise further in coming months, investors seeking income from their savings should find more opportunities out there.

But safe, traditional sources such as building society accounts and bonds will take time to recover from the history of low interest rates over the past 18 months.

Meanwhile equities - traditionally seen as income-generating - are far from promising given the recent decline in share yields. Investors who have traditionally looked to dividends to provide a reasonably steady income, because the returns are less volatile than the capital value of the share, have a problem: where can they invest for income?

Mark Dampier, investment specialist at Hargreaves Lansdown, an independent financial adviser, believes yields have been a victim of the excellent capital growth in the stock market. Even highly successful income-producing unit trusts have suffered. Jupiter Income has a current yield of just 2.99 per cent, while Newton Higher Income is paying 3.36 per cent.

"These are both flagship funds and rightly admired, but their yields are currently low. However, it is true to say that they offer the opportunity for capital growth," he says.

This is not much help for income-seekers, particularly as the future looks equally bleak for income-producing equity funds. "If you believe that technology will drive the economy in future years then traditional income funds will continue to face difficulties because it is a growth sector and is not paying any income," he adds.

The dividend yield is the annual return investors receive when they hold shares or unit trusts. It is expressed as a percentage of the cost of buying those investments. So if the gross dividend - the cut of the profits paid as income to company shareholders - from a share is £5, and the shares are trading at £100, the yield is 5 per cent. If shares rise to £200 but the dividend stays the same, the yield falls to 2.5 per cent.

As share prices have risen sharply over the past couple of years, yields have suffered, and so have income seekers. Even though the aim is to generate a regular income, these investors must now include an increasing number of growth stocks in their portfolio in order to protect the value of their capital.

More and more independent financial advisers are recommending growth stocks to income investors. Mr Dampier favours the HSBC UK Growth & Income Fund and Standard Life's UK Equity Growth Fund. "After all, there is no point in earning 6 per cent income if you are paying for it out of your own capital," he says.

But these choices should be balanced by some of the better-performing income-paying unit trusts. He suggests Royal & Sun Alliance's Equity Income, Framlington's Extra Income and Britannia's Higher Yield funds.

Justin Modray, at IFA Chase de Vere, says changes to the tax structure of individual savings accounts (ISAs) are likely to encourage a continuing move away from shares for income-seekers. Investors in equity ISAs can now only claim a 10 per cent tax credit on dividend income; even this reduced credit will be withdrawn from April 2004.

By contrast, investors can still claim the full 20 per cent tax credit on income distributions from corporate bonds held within the ISA structure, making them far more tax-efficient. Mini-cash ISAs also benefit in the same way.