AJ Bell's Dan Coatsworth highlights five flavours of income for ISA investors

As we hit peak ISA season, AJ Bell looks at five different flavours of income for ISA investors, including some specific investment examples.

“One of the key attractions of investments is the potential to earn a regular income,” says Dan Coatsworth, investment analyst at AJ Bell.

“As is common in the world of personal finance, there isn’t a one-size-fits-all approach for income investing. There are diverse ways to obtain a regular stream of cash rewards from an investment ISA, so make sure you pick the right one for your needs. Here are five methods.”

High yield

“For decades, investors have looked to investment markets to see if they can find something that offers a better yield than available on cash in the bank. The current benchmark to beat is 5%, being the best-buy savings account rate. That might seem a high bar to clear, yet qualifying opportunities are widespread across stocks, bonds, funds and investment trusts.

“The UK stock market is a treasure trove of high yielding stocks thanks to the plethora of low growth, yet highly cash-generative industries. Life insurance, tobacco and property feature heavily, with approximately one fifth of the FTSE 100 offering a prospective yield above 5%.

“Investment trusts are also a popular hunting ground, with big yields from companies across the property, renewable energy and debt sectors.

“While it is tempting to sit back and let the cash roll in, the income stream only forms part of the returns from an investment. It is important to also look at capital gains or losses.

“There’s no point owning a share, trust or fund if you’re consistently losing more money than you make from dividends. Total return is a term that looks at both capital gains/losses and income, and the goal is for that figure to be positive on a long-term basis.

“Yields can look high as a result of big share price declines. A falling share price reflects market concerns about something – such as tougher trading conditions or a lack of faith in earnings forecasts. If a company struggles for a long time, it might cut or cancel the dividend.

“Just because an investment offers a high yield doesn’t mean that dividend is sustainable – in fact, the high yield could be a red flag. It’s as important to weigh up what could go wrong with an investment as what could go right.

“Land Securities has a 7.2% prospective yield and has historically been an office and retail sector landlord. It’s now adding residential properties as a third bow. Commercial property might have been out of favour over the past few years amid a rising interest rate environment, but Land Securities has its eyes on the longer-term prize. That’s why it is hungry to increase retail exposure when others are retreating from the space. The plan is to shift the portfolio towards assets that generate a higher income for the group, which implies higher dividends for investors down the line.”

Monthly dividend payers

“People receive their salary like clockwork throughout their working life. While it’s reassuring to know that money is coming in on a regular basis to cover monthly bills, it can be a shock when someone retires and they no longer have that money topping up their bank account. Investments play a role in replacing that income – either selling small chunks to generate capital or, ideally, using dividends to pay the bills.

“Individual stocks typically pay dividends twice a year but that frequency might not suit someone who has monthly bills to settle. An investor could create a portfolio with dividends trickling in across different months. Alternatively, there is a growing number of funds and investment trusts paying dividends monthly to investors.

“Man Income Professional yields 4.3% and pays a monthly income to investors. Manager Henry Dixon aims to beat the FTSE All Share index by investing in companies of all sizes on the UK stock market. He looks for undervalued and unloved companies that have a dividend yield at least in line with the market.”

Dividend Aristocrats

“While income hunters may judge an investment on its dividend yield, it’s also worth considering dividend growth.

“The cost of living typically goes up each year so it’s important that dividends grow at least in line with inflation to ensure you maintain spending power. The ability of a company to grow dividends each year can also be a sign it’s a high-quality business.

“There are two ways to quickly identify investments with dividend growth. One is to look at investment trusts classified as ‘Dividend Heroes’ which are names that have consistently raised their dividends for at least 20 years in a row, including F&C Investment Trust and City of London Investment Trust.

“The other is to look at tracker funds labelled as ‘Dividend Aristocrats’. This is a term to describe companies with a long record of raising their dividend each year, often by 25 years or more.

“There are various ETFs which track a basket of companies classified as Dividend Aristocrats in Europe and the US.

“Not all investors need to take the income from their investments and they might choose to reinvest any dividends to enjoy compounding benefits. The prospect of owning an investment that aims to deliver consistent dividends or even dividend growth – such as Dividend Aristocrats – might appeal to them.

“SPDR S&P Euro Dividend Aristocrats tracks an index of 40 high-yield Eurozone companies that have had stable or growing dividends for at least 10 consecutive years. The index yields 4% and the ETF has achieved strong returns since launch in 2012. Annualised total returns over three years are 11% and 12.4% over five years.

“Europe is all the rage this year as investors turn their back on the US stock market and look for cheaper options in other parts of the world. The SPDR ETF is big in financials, utilities and industrials and top holdings include insurer Ageas and pharmaceutical group Sanofi.”

Enhanced income

“Income-hungry investors are often happy to receive the bulk of their returns from dividends rather than capital gains. There is a specific type of fund that might appeal to this type of person.

“Enhanced income funds (also known as ‘income maximiser’ funds) have a clever trick up their sleeve to boost their dividend power. They might generate a 4% or 5% yield from their underlying portfolio but have a neat way to pay even more to investors.

“They sell call options on stocks held in the portfolio to generate additional income. These options are contracts that give the buyer the right, but not the obligation, to buy the underlying asset at a specific price on or before a certain date.

“For example, an investment bank buys an option on Company X from an enhanced income fund for a fee. This entitles the investment bank to any rise in the price of the underlying share above a certain level over a set period, typically three months. The enhanced income fund uses the option fee to top up its dividends, but in doing so it sacrifices part of the capital growth from the stock holding.

“Enhanced income funds might underperform traditional equity income funds when markets are rising but potentially outperform in a falling market.

“Call options can be difficult to understand and charges on enhanced income funds are often much higher than a traditional equity income fund. That means these types of funds won’t suit everyone.

“Schroder Income Maximiser targets 7% yield, albeit not a guaranteed payout. The bulk of its portfolio is in UK shares, but it also has money invested in US, French, Italian and German-listed companies, as well as a small amount in money markets.

“The top holdings list is a who’s-who of big-name dividend payers in the FTSE 100 including British American Tobacco and Imperial Brands.

“Charging 0.91% a year, the fund has rewarded investors handsomely in the past. Annualised total return, which incorporates share price gains and income, is 14.8% over the past five years and 10.1% over three years. That compares to 10% and 6.4% annualised returns respectively for the Investment Association UK Equity Income sector average.”

Blending income and growth

“The blended approach of income and growth is increasingly popular with investors who want a happy medium of dividends and capital gains.

“Someone in retirement looking to make their pension last longer might use this approach. So might an individual who wants their investments to grow and use cash from dividends to fund additional investments down the line.

“JPMorgan Global Growth & Income has won fans in recent years, helped by robust performance and offering more jam today than previous investor favourites such as Scottish Mortgage which is more about jam tomorrow.

“The global ‘best ideas’ investment trust is pushing on £3 billion in market valuation and has hoovered up other trusts in recent years. Another deal is on the cards, gobbling up Henderson International Income which will increase its assets under management.

“Annualised total returns are 10.6% over three years and 22.1% over five years. The portfolio features a blend of tech, media and retail names as the dominant holdings, alongside a sprinkle of other sectors on a smaller basis.”