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

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

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.....continued below

Advertisement starts

Advertisement ends

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.