Paltry savings rates have seen investors flock to stocks and shares Isas, but those seeking alternative income streams to cash could unwittingly be taking big gambles.

Money is pouring into corporate bond and equity-income funds, which can both be held within a stocks and shares Isa, since some are yielding up to 10% against an average of only 1.99% for cash Isas.

However, advisers said many savers may not appreciate the risks. Graeme Lind at adviser Towry Law said: “As a rule, the higher the income yield, the bigger the risk to your capital. We would recommend that anyone thinking of moving out of cash balances their need for income with the level of risk they’re prepared to take. Would you be prepared to lose 20% in a year?”

Here, we highlight the hidden risks to watch for when searching for Isa income.

GILTS

Gilts, which are bonds issued by the British government when it needs to raise money, are one level higher than deposit accounts on the risk scale. Investors in individual gilts get a fixed rate of return and their capital back at maturity — unless the government is unable to honour its commitment.

However, there is still a risk to your capital if you invest in a gilt fund rather than individual government bonds. Once issued, gilts are traded on the open market and prices can rise and fall with demand. If you sell when prices are low, you could get back less than your original investment.

Recently, prices have shot up as investors have rushed to take advantage of their fixed return. The UK gilt sector was the best performer last month with a gain of nearly 2% and is up nearly 8% over a year.

The Bank of England’s decision to embark on quantitative easing — in effect buying assets such as gilts to boost the money supply — should support prices in the short term. Some analysts fear that inflation will return and interest rates will rise, which could see gilt prices rise (and yields fall).

Darius McDermott at Chelsea Financial Services said: “Rising inflation and the level of new issuance in the gilts market are concerns, but in an environment of rock-bottom cash rates, gilts present a lower risk option for cautious investors.”

He likes the City Financial Strategic Gilt fund and Allianz Pimco Gilt Yield fund, yielding 3.4% and 3.9% respectively.

CORPORATE BONDS

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