Three ways to boost your income

We may be facing a replay of the 1930s, but don't despair if you can handle a bit of risk, you can still earn a decent return on your money, says Tim Bennett.

Investors can be forgiven for feeling glum. We could well be facing the worst recession since the 1930s, and there's no sign of any light at the end of the tunnel. Government bail-out packages and rapid interest-rate cuts seem to have done very little to encourage lending, but have succeeded in demolishing the return on our savings.

But this isn't the time to despair. Yes, the FTSE 100 sank by a third last year. And volatility, and therefore uncertainty, is still high the CBOE Vix (also known as Wall Street's 'fear gauge') is still at 50, having been as low as 16 in the past 12 months. But as long as you're prepared to accept some risk to your capital, you can still earn a relatively safe income of at least 6% no lottery win but perfectly decent with Retail Price Index (RPI) inflation at 0.9%. Here are three of the best options from least to most risky.

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1. Buy corporate bonds

We had an in-depth look at corporate bonds in issue 418 (Find your way round the bond markets), but in short, these are (typically) fixed-income IOUs, issued by companies to raise cash. They have stepped out of the large shadow cast by the more popular equity market in recent months, largely down to some tempting yields they pay from around 5%-7% on average, but up to 10% or more for riskier high-yield paper. Better still, the interest income that creates those yields is more secure than the dividend on a stock because it has to be paid out of profits first. Should a firm go bust, bonds get an earlier bite at the cake when it comes to claiming money back.

On the other hand, don't try to trade bonds this market doesn't offer a quick buck. And unless you're a gambler, avoid high-yield debt, or both your income and capital may vanish. Access can also be a problem not all brokers offer all such bonds. But you can get most of the best known via the likes of Barclays Stockbrokers (0845-601 7788) or Hargreaves Lansdown (0117-980 9800).

On an individual basis we like 'plain vanilla' blue-chip sterling bonds, such as the Tesco 5.5% 2019, yielding 5.2%. But in the case of corporate bonds, it makes more sense for most investors to buy a fund it'll spread your risk too. There is an exchange-traded fund (ETF) that tracks UK corporate bonds the iShares Sterling Corporate Bond fund (LSE:SLXX) which has an expense ratio of just 0.2% and yields 7.4%. However, just over 60% of the fund is allocated to the ailing banking sector. A more cautious option would be to go for a managed fund Mark Dampier at Hargreaves Lansdown likes the Invesco Perpetual Corporate Bond Fund (TEL). It yields a chunky 6.9%, with just one bank (Barclays) among its top ten holdings. The initial charge of 5% may be cut if you buy through a broker.

An alternative Prefs and Pibs

Preference shares (Prefs) occupy the middle ground between corporate bonds and shares. They carry a fixed coupon (which accumulates if left unpaid), but they rank below all bonds if a firm is going bust. And there's the rub yields can be pretty decent, but there is risk attached, particularly as prefs tend to be issued by financial stocks. A further headache is that the market is fairly small and dealing costs can be high. Should you still want to persevere, Peter Temple tips the Aviva 8.375% cumulative preference share. It yields around 8.5% gross (thanks to a tax quirk, dividends on prefs are not subject to further standard-rate tax). A broker such as Collins Stewart (020-7523 8000) can set up the deal.

As for permanent income-bearing shares (Pibs), typically issued by building societies, again we would be wary. Although some yields, such as Bradford & Bingley's (B&B) 38% (see Thisismoney.co.uk/pibs), look spectacular, that's because the future of the entire issue is under threat as the Treasury works out how much compensation to pay to former B&B share and Pib holders. Mergers between existing building societies complicate the picture for other Pib holders. In short, high yields signal danger rather than a free lunch. If it's a reasonable degree of safety you're looking for, we'd stick with one of the bond funds mentioned above.

2. Buy safe blue-chips

Here's the bad news more share-price falls seem likely. Strategist Albert Edwards of Socit Gnrale (SocGen) sees further falls of 20% globally in 2009 as demand collapses around the world, led in large part by a massive slowdown in China. That doesn't mean you should ignore shares. But it does mean you can't just pile into any old stock with a juicy dividend yield on the basis that 'the bad news is in the price'. As firms conserve cash, some dividends will be cut it's inevitable. You might even lose your initial investment if you pick a company that goes bust. In the 1990s insolvencies hit 30,000. Ric Traynor of insolvency specialist Begbies Traynor says "there is little reason to assume the figure will peak at anything less this time". A big dividend yield is only attractive if a firm can maintain it. So equity investors need to do their homework to check how sustainable pay-outs are. Every individual test of dividend strength has drawbacks, so it's best to do several.

First, check dividend cover you'll find this on investment websites such as Digitallook.com or in the FT's Markets section. The ratio reflects the number of times a firm's profit before dividends covers its full-year dividend. Check both the historic figure for the last 12 months and the forecast for the coming year. Anything less than two times (as a benchmark the FTSE 100 average is around 2.5) signals possible cuts.

Next, check cash flow. Big, regular dividends paid half yearly or even quarterly can be a substantial drain on a firm's cash. As dividends are discretionary payments, they can be slashed quickly. Ratings agency Standard and Poor's reckons 2009 could be the worst year for dividend cuts since 1958. So look on the cash-flow statement for any sign that 'cash flow from operating activities' is falling rapidly. Also check 'free cash flow'. This is the same number less interest payments, tax and one year's depreciation charge (which gives a rough idea of the amount the firm needs to spend to maintain existing fixed assets). A big drop spells possible dividend cuts.

Then watch for another threat to dividends that comes, ironically, from firms with big cash piles acquisitions. You are not paying a firm's directors, as a shareholder, to sit idly on cash. But that means they can be very tempted to spend it, rather than pay it out to you. So, for example, drugs giant Pfizer offering a yield of 7% is splurging billions on buying rival Wyeth. Pfizer has already warned that the £48bn deal threatens future dividends. So keep an eye on corporate news flow and sectors that look prone to consolidation. Finally, check the price/earnings ratio (p/e). Too high, say well above the FTSE 100 average of about 8.5 for a UK firm, and you may be overpaying to get a steady dividend.

The most important test

These tests are all well and good, but they won't tell you whether a firm might go bust. No indicator is foolproof, of course, but the Altman Z score is better than most. Devised in the 1960s, Edward Altman claims the model will predict "70%-80% of bankruptcies of publicly listed companies before they happen". It works by taking five key ratios, then weighting each according to its relative importance before adding them up to get a single score.

The first of the five is working capital to total assets, the idea being that if the business is losing cash quickly, working capital will shrink fast. Next, retained earnings to total assets big asset write-offs are a danger sign and will show up in reduced retained earnings. Third and with the heaviest weighting is the ratio of earnings before interest and tax (EBIT) to total assets, a key measure of the firm's total return on the assets it employs. Then Altman looks at market capitalisation to total liabilities to add what Peter Temple on Iii.co.uk calls a "stockmarket dimension" to the calculation. In short, any firm whose market cap is at risk of falling below the level of its liabilities is in trouble. Lastly, the ratio of sales to total assets offers a snapshot of how well management uses the firm's assets to generate turnover and, hopefully, cash flow. If you want to check a firm's Z score yourself using the latest profit and loss account and balance sheet for a particular firm, try looking on Creditguru.com.

A score of three or above is considered safe; anything below about 1.8 is a red flag. It isn't perfect. It doesn't work terribly well for asset-heavy financial services firms and property companies but then we wouldn't touch either sector with a barge pole right now. New firms with low profitability can also get low scores, but they are hardly likely to offer big dividends anyway.

Four companies with secure yields

So which firms do we like the look of on this basis? The following FTSE firms all already offer a decent dividend yield well above the latest RPI inflation rate of 0.9% combined with solid dividend cover, cash flow and a Z score of three or above. They all also trade on fairly low p/e ratios, so offer scope for long-term capital growth too.

First we have the oil majors BP (LSE:BP) and Shell (LSE:RDSA). They yield 6.4% and 5.7% on p/es of six and five respectively. Forecast dividend cover is2.7 and 3.3 times, their Z scores are 3.4 and 3.6. An oil price of $25 a barrel, as forecast by MerrillLynch, would threaten revenues, and perhaps dividends at both.But that seems unlikely with the price at $47 on the back of Opec's promises to cut production. The arms industry is a classic defensive sector, which makes aerospace and defence engineer Meggitt (LSE:MGGT) attractive on a yield of 6%, covered 2.7 times with a Z score of 3.3. The p/e is 6.4. Finally, one that might come as a surprise: retailer Halfords (LSE:HFD). Life is tough for retailers just now, but the group sells essential car, bike and home accessories. Car sales may have dived, but arguably that means more call for parts as people run their old bangers for longer. And bike sales are rising as a green and cheap alternative to motoring. The yield is 6.5%, with a p/e of eight and forecast cover of two times. The Z score is 4.7.

3. The covered call

Finally, for the more technically minded, adventurous, income investor, there are 'covered calls'. Fund managers haven't been slow to hop onto the quest for income and try to make money from it. Many of the latest equity fund offerings, such as the Schroders Income Maximiser, promise high yields around 7% in this case. To do this they supplement dividend income received from the portfolio's shares by selling call options on shares they already hold. These are known as covered calls because, should the holder of the option exercise it and demand shares, the fund manager is covered by already owning them.

Such a strategy can enhance yields but it does push up risk the Schroder fund lost around 22% over the past year. That's better than a FTSE tracker, but it's a lot worse than cash. Fees are also on the high side the initial fee is 5.25%, while the annual management fee is 1.5%. And as Dampier comments, you don't really know "what's going on under the bonnet". But the good news for those who have some understanding of options and don't mind taking a bit of extra risk is that the covered call strategy can be replicated without paying a fund manager.

Let's say you hold 1,000 Marks & Spencer (M&S) shares trading at £2.20 each. You are bearish about the near-term prospects for the firm, but want to hang onto the shares, rather than sell them. This gives you the opportunity to make some extra income from your shares while you wait for them to recover. You could sell a three-month M&S call option via your broker on the shares with a strike price of £2.25 for a premium of, say, 24p per share. So you immediately bank around £240 (24p x 1,000), less any dealing costs. That's an immediate yield of 12.2% (24p/£2.20-0.24).

If M&S shares fall as you expect, the holder of the call won't exercise it and the £240 is yours. Indeed, you are protected against a fall of up to 10.9% (24p/£2.20) in the value of your shares (because your gain from writing the option offsets the fall in the capital value of your shares). But should the M&S share price rise, you could deliver them to your broker at the strike of £2.25 to bank an extra 2.2% (5p/£2.25 x 100). The downside, of course, is that you don't then get to hang onto your shares. However, this isn't usually an option for retail investors. Instead, you will usually have to 'close out' your position by buying back the call option although you'd have to pay more than the original £240 to do so.

You can sell call options on a wide range of stocks, or even on an index such as the FTSE 100, via a broker such as IG Index.

Inflation protection is now 'outrageously cheap'

One big enemy of income investors particularly fixed-income investors is inflation. And as President Barack Obama mulls the next huge American bail-out package it seems an irresistible force "gigantic amounts of fiscal and monetary stimulus", as John Hollyer at Vanguard Securities puts it, is about to hit the immovable object of a deep recession.

So investors face two very different outcomes. The world economy might be caught in a Japanese-style deflationary trap. Alternatively, once the world's money printing presses are cranked up, the vast injection of newly minted notes (or electronic digits, at least) will chase a dwindling supply of goods and services. And that spells inflation.

No one really knows for sure which will happen next, but we suspect that inflation will be back more rapidly than most people are assuming. One investment class offers the promise of a maturity payment with government backing, low price volatility and the prospect of rising income should inflation make a comeback. Better yet, it's cheap. In America it's called the Treasury Inflation Protected Security (TIPS). Here in Britain, the equivalent is the index-linked gilt, or 'linker'

In both cases the buyer gets a government IOU. Coupons are paid at regular intervals six monthly, in the case of TIPS. However, unlike on standard bonds, your returns are increased (or reduced) to reflect inflation. So the return you get is real ie, inflation-adjusted. This compares well with the nominal return from a standard Treasury or gilt, where the coupon is fixed regardless of inflation. But that's not all. As Steven Goldberg points out on Kiplinger.com, TIPS are "outrageously cheap" because the bond markets are assuming inflation is dead. Indeed, current prices suggest TIPS will outperform regular Treasuries "if inflation is no more than 0.5% a year for the next decade". That's a long time, given that the average for the past decade is 2.6%.

While you can buy individual US Treasuries and UK gilts, we think exchange traded funds are a more straightforward bet. For Treasuries, try the iShares Barclays TIPS Bond (NYSE:TIP), and for "linkers" the iShares index-linked gilts tracker ETF (LSE:INXG).

Don't forget the tax breaks

An easy way to give your income a boost is investing via individual savings accounts (Isas) and pensions. Wrapped inside an Isa, dividend income is tax-free, along with interest payments on bonds. Capital gains on shares and bonds are sheltered too (note corporate bonds must have a minimum five years to go until maturity to qualify for an Isa). And you can park up to £7,200 in an Isa this tax year. It's 'use it or lose it', so get cracking if you have yet to use up your allowance.

Personal pensions, on the other hand, give you tax relief on the amount you contribute at your marginal income-tax rate. So every 60p paid in by a higher-rate taxpayer becomes £1 of investment, provided you remember to claim full relief on a self-assessment tax return. A 'self-select' pension, or Sipp, which can be organised through a broker such as Hargreaves Lansdowne, gives you plenty of choice about where the money is invested.