Bright sparks will go for growth as income funds face rough ride

Income is the holy grail for many investors: bond and equity income funds usually battle it out for the top-selling slot in monthly investment statistics. This year, however, income-seekers face a dilemma as both of these popular sectors face a more challenging outlook.

Equity income funds have had a stellar three years: New Star's UK Strategic Income, the best performer over that period, has risen close to 150 per cent while funds from Jupiter, Framlington, Artemis and Invesco Perpetual have produced returns of more than 70 per cent.

While gilt and corporate bond fund returns look pedestrian by comparison - the best-performing have generally risen by just under 30 per cent over three years - that is still a decent performance from a sector that is usually bought for income rather than capital growth.

Indeed, government gilts and the best-rated corporate bonds have been so popular in recent years, as pension funds have fled the stock market and risk-averse investors have shunned equities, that they are now looking very full-valued. As prices have risen, so the yields available from them have fallen sharply. Indeed, the average bond fund now offers an income of about 4 per cent, not that much more than the 3.5 per cent or so from an equity income fund. Given that an equity fund should also offer the prospect of longer-term capital growth, it is hardly surprising that many financial advisers think bond funds are not a great place to put your money at the moment.

Indeed, some go even further and warn that they are becoming risky. John Kelly, head of client investment at Abbey, thinks that investors' conviction that interest rates and inflation will stay low has made bonds look expensive. But he adds that there has been a 'revolution' in the management of bond funds, with even apparently conservative sterling bond funds using derivatives and hedging devices to chase yield overseas. If bond markets get more volatile - as seems likely given the uncertainty about interest rates here and, more importantly, in the US - then managers face big challenges in keeping their quoted yields.

Even those who are not as pessimistic as Kelly think that next year will not be that exciting for most mainstream bonds. Theo Zemek, head of fixed income (strategy) at New Star, says: 'We start the year with inflation slowly rising, and real yields at historically low levels. None of these are very favourable conditions for people to be investing in the government market. We think that 2006 will see a dull but worthy year for lower-grade corporate bonds, and possibly a more difficult year for government bonds.'

Equity income funds are not a safe bet either. Their purple patch can't last forever, and even income fund managers such as Richard Hughes at M&G believe the stellar performance of higher-yielding 'value', at least relative to so-called 'growth' stocks, could be coming to an end.

As the chart shows, growth companies have lagged far behind value stocks since the market crashed almost six years ago. Justin Modray, at financial adviser BestInvest, says the rating of growth stocks is about 1.5 times that of value stocks, well below the long-run average of 2.4 times, while the FTSE 350 low-yield index, an approximation for growth stocks, is cheaper, relative to high yield stocks, than it has been at any time in the past decade.

Hughes agrees that high-yielding shares, like water and electricity companies, have had a very good run and that, with the relatively benign economic climate, growth funds could now start to outperform. But that does not mean equity funds will plummet. 'If income funds underperform, it will only be because we are up by 10 per cent while growth funds rise by 12 per cent,' he says. 'That is not the end of the world.'

Certainly, the statistics show that, over the longer term, a good income growth fund will produce excellent returns: over 10 years, the best income funds - from Rathbones, Jupiter and Invesco Perpetual - have almost trebled in value while the FTSE 100 index has only risen by about a third. Not surprisingly, Tim Cockerill at Rowan includes these three, along with income funds from Artemis and Framlington, among his top buys. He thinks that equity income funds look more attractive than fixed income, despite the stock market risk, although he adds that a bond fund should be part of any diversified portfolio.

Philippa Gee, from financial adviser Torquil Clark, is impressed by a new multi-manager equity income fund being launched by Fidelity, which will pick what it believes are the best six funds in the sector. That, says Gee, relieves investors of having to decide which is best to buy, and working out when to sell them. While the charges on a multi-manager fund are slightly higher than investing directly in a fund, Fidelity is capping the total expense ratio at 2 per cent - lower than some other multi-manager products.

BestInvest's Modray says property funds, which have just been allowed into Isas, are another good bet for income seekers. While property prices have risen sharply, so there may not be much capital appreciation to come, the structure of the British commercial property market, with long leases and upward-only rent reviews, means the income is relatively secure. He sees property funds from New Star, Scottish Widows and Norwich Union as particularly attractive.