Name's bond, income bond

Bonds can cut the risk and deliver a decent return

Investors looking for income are often baffled by the wide choice. Some products are relatively familiar, such as National Savings certificates, but corporate bonds and with-profits bonds can seem more daunting.

Investors looking for income are often baffled by the wide choice. Some products are relatively familiar, such as National Savings certificates, but corporate bonds and with-profits bonds can seem more daunting.

But you don't have to stick with the tried and tested. With low interest rates hitting income from investments you should explore every opportunity to boost returns.

You might also have to accept a higher level of risk than a few years ago, says Justin Modray, investment adviser with Chase de Vere. "To get a good return for low risk is very difficult. Bank and building society deposit accounts have traditionally been safe vehicles but even the best pay no more than 6 per cent income, without capital growth."

Corporate bonds are an increasingly popular option, offering an alternative to the bumpier, but potentially more rewarding, stock market. Corporate bonds are loans issued by companies to raise money for their expansion. They pay investors a fixed rate. The risk you take is that the company may default on its payments, but this can be reduced by spreading your money across a variety of companies using a corporate bond fund. "These pay between 5 and 6 per cent gross income with a reasonable chance of capital growth," says Mr Modray.

Bonds are traded like shares, and their price can rise and fall depending on how attractive the income they pay looks, compared to cash or shares. Returns are variable but can rise to as much as 9 per cent. "There has been a proliferation of high-yield bonds such as M & G Higher Yield and Fidelity Extra Income," says Mr Modray. "These are attractive rates, but they invest in smaller companies with a greater chance of defaulting."

Guaranteed income bonds are also more popular, because they allow exposure to the potentially higher returns of the stock market, while protecting your initial capital. "They give you a high guaranteed rate of interest for three to five years and return your initial capital, provided the stock market index has not fallen," says Mr Modray. "They are attractive, simple and give a greater level of income than savings accounts. The downside is that if the stock market has fallen at the end of the term, capital will be reduced."

The Scottish Mutual Income Bond pays 8 per cent net income for three years and returns your original capital if its chosen index, the Euro Stoxx 50, is no lower at the end of the term. The NPI High Income Bond pays 8.25 per cent annual income with a full return of capital, again provided the Euro Stoxx 50 has not fallen over the three-year term.

Many advisers are wary of three-year bonds because it may not be enough time to make good any stock market fall. With-profits bonds, sold by insurance companies, are another way of tapping into stock market returns while reducing the risk of a crash or correction eating into your savings. Gains on the bonds' investments are shared out to policyholders each year. Once declared, these bonuses cannot be taken back, protecting you from future stock market falls. Your original capital is also protected.

Martyn Laverick, marketing director with Chartwell Investment Management, says: "Annual bonuses are typically around 5 per cent net which can be taken as income." A final, larger payment, called a terminal bonus, is paid to policyholders during the term of the bond or when it is cashed in.

Mr Laverick says the Prudential with-profits bond, which pays a bonus rate of 5.25 per cent and a terminal bonus of 2.75 per cent, remains the most popular, followed by Norwich Union and Scottish Widows.

Basic-rate taxpayers pay no further tax on the proceeds from with-profits bonds. However, with-profits bonds pay advisers up to 5 per cent commission, which comes out of your pocket. But this can be greatly reduced by buying on an "execution-only" basis through companies such as Chartwell or Financial Discounts Direct. You should keep some part of your portfolio as cash to reduce exposure to risk and keep a source of accessible funds.

You can take the interest free of tax by putting your cash in an individual savings account (ISA), which allows you to invest £3,000 in cash this financial year (£1,000 in future years). Rates of around 6.5 per cent are available, but these may fall.

You can also invest up to £7,000 this year (£5,000 thereafter) in a stocks and shares income-bearing ISA. Returns vary greatly according to investment performance, but in the 12 months to November a £1,000 investment in Jupiter Income would have risen to £1,221. If you took all this as income it will have paid 22.1 per cent. You should put only part of your funds in the stock market because of the greater risks.

The rates of National Savings have recently improved. Mr Laverick says: "Its index-linked certificates are now worth a look, especially for higher-rate taxpayers." The index-linked five-year certificate (16th issue) pays the inflation rate, plus 1.8 per cent a year tax free, if you tie your money up for the full term. Its index-linked two-year certificate (1st issue) pays inflation plus 2.5 per cent.

Chartwell, 01225 446556; Financial Discounts Direct, 01420 549090