The objective of the higher income plan is to achieve for investors an acceptable level of risk to c...
The objective of the higher income plan is to achieve for investors an acceptable level of risk to capital, commensurate with a relatively high and stable level of income. These funds have successfully demonstrated over the years that both elements can be achieved. On this basis, absolute return should be targeted rather than following an index.
It is perhaps predictable that the average age of investors is nearly 70. Most IFAs have sold these funds to retired people who are generally by definition, dependent upon a reliable and regular stream of income. A higher income plan is particularly useful to this group of people as it pays its income monthly, straight into bank or building society accounts, and allows them to make their financial arrangements in advance.
Generally, our investors have bought into the Higher Income plan via a Pep or Isa and are therefore currently enjoying a high and tax-free income. The fund has also been bought by many clients of IFAs looking for an alternative to an annuity to boost withering pension incomes. Although this fund's income is not guaranteed, the advantage it has over an annuity can be found on the capital side. The plan's objective is to keep the fund price as stable as possible. Although the fund price is not expected to appreciate markedly over time, it is reasonable for investors to expect a good chance of their original capital being returned after, say, five years, unlike an annuity, where the capital dies with them.
Finally, higher income plans are a useful Pep transfer vehicle. Over the years, and often prior to retirement, many investors have accumulated substantial Pep investments. These investments have grown within a variety of Pep growth unit trusts, on the back of one of the longest bull markets on record. The funds are now being 'bundled' and transferred into income Peps allowing investors to take a substantial and additional tax-free income for life.
The yield on Foreign & Colonial's Higher Income plan is over 8.25% on an annualised basis. This level is far in excess of money market accounts and compares very well with corporate bond funds. The key advantage of a higher income plan over corporate bond funds is that the investment risk is not concentrated in corporate credit spreads.
Since the launch of Foreign & Colonial's Higher Income fund in 1993, it has evolved significantly to keep pace with changes in the investment market and to maintain the efficiency of the fund for investors.
It currently consists of two core asset classes, namely UK equities and sterling denominated bonds, with weights of 30% and 60% respectively. The equity basket closely resembles the FTSE-100 in composition and the dividend flow from the equities contributes to the fund yield.
Halifax and Glaxo
The sterling denominated debt is made up of two distinct types of bond. Approximately 55% of this total is invested in high-grade UK corporate bonds and includes holdings in companies such as the Halifax and Glaxo. The average bond maturity is approximately eight years. This element is used to provide the fund with a relatively stable yield and over the long term, the limited exposure to credit risk should add value in a controlled manner over the returns available in the government bond market.
The remaining 45% is invested in what we originally termed 'special debentures'. The key feature of these bonds is that they contain options and have an abnormally large coupon. The maturity of these bonds varies between three months and five years. If we assume that the equities within the portfolio are yielding 2.1% and the remainder of the portfolio yields 6.75%, which is the current four-year money market rate, the portfolio would only yield 5.36%. There is thus a significant shortfall between this figure and the headline yield on the fund. This shortfall is made up by selling some of the future expected upside of the fund via derivative instruments, which are then embedded in the special debentures.
The remaining 10% of the fund consists of cash and other instruments. The cash element usually makes up between 3% and 5% of a fund. The other instruments category contains trades that are entered into to add value to the portfolio over time, while further diversifying the sources of return within the fund, as well as hedging instruments that are in place to lower the volatility in turbulent times.
A good example of an added value trade is a three-year dividend swap Foreign & Colonial entered into last year. The payoff of the trade is based on the sum of dividend payments made by companies within the FTSE-100 index over the next three years minus the amount paid to initiate the trade. Due to a technical position in the derivatives market at the time, the total dividend payment from the FTSE-100 could fall by over 12% before the trade became unprofitable.
Given the current economic climate, it would be expected that dividend payments would increase over the three-year period. The risks of the trade were that following the US model, cash would be increasingly returned to investors by stock buy-backs and that the dividend yield of the FTSE-100 would fall due to index constituent changes.
For example, when Vodafone merged with Airtouch, Vodafone's benchmark weight increased but as one of the lowest yielding stocks in the index at the time, it dragged the average yield of the index down. Despite the detrimental index component changes that have impacted the trade over the last year, the first year has yielded a handsome return on this trade. A secondary feature of this trade is that while it is based on the FTSE 100, its profitability is not directly linked to the absolute level of the index and so adds a further element of diversification to the fund. For example it is feasible that the index may fall over the year but dividend payments rise.
The income requirement of hi