Mark Dampier: Royal London Sterling is worth considering

The Analyst

When interest rates were cut to the "emergency" level of 0.5 per cent in April 2009 hardly anybody expected them to stay there for more than a few months. Yet here we are in mid-2011 and I still see little sign of rates rising. The pressure is mounting on those who want their savings to deliver more income, but unfortunately there isn't an easy answer. Those who want a higher income are going to have to take more risk to get it, and that means giving up the safety of cash in exchange for the uncertainty of the bond or equity markets.

Clearly keeping some cash is important. It is vital to have readily available money for emergencies, but you simply have to accept the fact that the return on it is going to be very low. For many long-term investors a portfolio of UK equity income funds and bond funds could provide an attractive level of income and be sufficiently diversified to lessen risk.

One of the traditional safe havens for income investors is government gilts. Yet 10-year gilts yielding 2.4 per cent gross hardly look attractive. Locking into this measly yield for 10 years looks like a poor deal to me unless you believe we are following a Japanese template of severe deflation. It is quite conceivable that gilt yields could fall below 2 per cent in that scenario, but if (like me) you believe the economy will muddle through it is hard to make a strong investment case for gilts yielding their lowest amount since the 1890s. Interestingly, it turns the idea of a "safe" investment on its head. Although gilts would continue to do well in a deflationary scenario, the upside looks fairly limited compared to the downside in the event of an inflation scare. An inflationary environment could be devastating for gilt prices and for those who have flocked to them as a perceived safe haven.

For those prepared to take on a greater degree of risk as part of a diversified portfolio, a high yield bond fund such as Royal London Sterling Extra Yield managed by Eric Holt is worth considering. It is not a direct alternative to gilts because, like any corporate bond fund, it relies on the creditworthiness of the companies it holds, and with a yield of nearly 7.5 per cent it is clearly one of the more risky bond funds available. However, I like the fact that it invests in a different range of fixed interest securities to most bond funds, so it does bring something different to a portfolio.

Only a small amount is invested in "investment grade" bonds (those issued by high-quality companies where the risk of default is perceived to be low), and exposure is primarily to more risky high-yield bonds. Indeed some 30 per cent of the portfolio has no credit rating, though that simply means no rating agencies have been paid to look at the companies. As compensation for the additional risk investors tend to get a higher yield. Therefore, much of Mr Holt's work involves analysing credit risk himself to see what level of safety bond holders actually have. In many cases he finds the company has sufficient tangible assets that in the event of default they would still get most or all of their money back.

The fund undoubtedly suffered in 2008 when corporate bonds fell dramatically in tandem with equity markets. At that time there was genuine panic that company defaults would increase rapidly, plus many institutions and hedge funds became forced sellers in order to raise cash to shore up balance sheets or meet fund redemptions. Mr Holt believes the fund is more resilient today and has positioned it for an economy bumping along the bottom, which is where I think we are headed as opposed to an outright recession.

If you feel we are going to slide into a severe recession this probably won't be the fund for you.

High-yield bonds would be vulnerable in a full-scale downturn. However, supported by an exceptionally high yield, this fund is a nice halfway-house between UK equity income and a more secure corporate bond fund for those who are more optimistic.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent