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Forget a Cash ISA! I’d buy FTSE 250 dividend stocks in a Stocks and Shares ISA

While the FTSE 250 may be viewed as a means to generate high capital growth in the long run, it could offer surprisingly strong income prospects too.

The index yields just 3% at the present time. However, with a Cash ISA offering 1.5% at best, and the FTSE 250’s income return being ahead of inflation, the index could offer an impressive income outlook.

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Furthermore, a number of its members could produce high dividend growth rates. It may also be possible to build a diverse portfolio of mid-cap shares that, when combined, have a yield that is significantly higher than 3%.

Growth potential

With the FTSE 250 having recorded annualised total returns of around 9% in the last two decades, the long-term growth potential of the index is clearly high. This growth rate includes two major bear markets (the dotcom bubble and the financial crisis), as well as the recent downturn in performance for the UK economy. In fact, the index currently trades just 8% higher than it did four years ago, with its performance having been negatively impacted by weak investor sentiment following Brexit.

Rising dividends

The growth potential offered by the index’s members may mean that they are able to deliver rapidly-rising dividends. Since they are smaller companies than their FTSE 100 peers, they could produce faster-rising bottom lines that translate into strong dividend growth. Although a portion of their increasing profitability may be used to reinvest for future growth, a part of it could be used to grow their returns to shareholders. As such, the index’s current income return may grow at a relatively brisk pace.

Income prospects

In the near term, it is possible to generate an income return that is significantly higher than the index’s 3% yield from buying its higher-yielding constituents. For example, 54 FTSE 250 shares currently have yields that are in excess of 4.5%. An investor may, therefore, be able to build a portfolio of stocks that together has a combined income return of over 5% in the current year. This could allow an investor to not only generate a higher return than a Cash ISA and the FTSE 100, but also benefit from the long-term growth potential offered by mid-cap shares.

Risks

Of course, the FTSE 250 is a far riskier place to invest when compared to a Cash ISA. It is possible to lose capital on any of the index’s stocks, with risks such as Brexit having the potential to weigh on the performance of what is a UK-focused index.

However, the FTSE 250 has always recovered from bear markets and recessions to post higher highs. This trend is likely to continue in the long run, with its present-day valuation suggesting that it offers a margin of safety. As such, for income investors who have a long-term outlook, it could offer a much more appealing risk/reward ratio than saving through a Cash ISA.

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Peter Stephens has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.