Investing In Retail Bonds
.jpg)
It is a truism that in the long-run, nothing beats
the stock market in terms of investment performance.
This being the case, why would anyone invest in
bonds, and specifically in this context, a retail bond? Despite the fact that
they pale in comparison to equities as a long term investment vehicle, bonds
have several traits that stocks simply can't match.
A key feature of a retail bond is
predictability – a bond, because it is a loan, carries an interest rate and as
a contract to the borrower the interest is paid in a fixed sum or index linked
sum on specific dates each year. As the money gets paid on a specific date you
can build a portfolio as you know precisely when income comes in. As long as
the issuing company is fine you know exactly how much you’ll get.
Secondly, there is capital preservation. Unless a company goes bankrupt,
a bondholder can be almost completely certain that they will receive the amount
they originally invested. Stocks, which are subordinate to bonds, bear the brunt
of unfavourable developments.
Thirdly, bonds pay interest at set intervals of time, which can provide
valuable income for retired couples, individuals, or those who need the cash
flow.
For instance, if someone owned £100,000 worth of bonds that paid 6%
interest annually (that would be £6,000 yearly), typically a portion of that
interest would be sent to the bondholder biannually, giving them money to live
on or invest elsewhere.
Bonds can also have large tax advantage for some people. When a
government or municipality issues various types of bonds to raise money to
build bridges, roads, etc., the interest that is earned is tax exempt. This can
be especially advantageous for those whom are retired or want to minimise their
total tax liability.
When you begin to invest in bonds for the first time, you may hear your
broker or other investors refer to the “coupon”. A £25,000 bond that paid 6%
interest might be said to have an 6% “coupon”.
For new investors who don’t know the history of the stock market or the
bond market, this may be confusing and seem odd.
Where the Term Coupon
Originated for Bonds
Back in the days before computers,
when an investor bought a bond, he or she was given a physical, engraved
certificate. They would then go lock these in a safe deposit box. It was
important that they be kept secure because it was the proof that they had lent
money to the bond issuer and it was what entitled them to receive their money
back, plus interest. Each of these bond certificates included an attached
section of “coupons” with dates printed on them.
Twice a year, when the interest was
due on their bond, the investor would go down to the bank, open the safe
deposit box, and physically clip the proper coupon with the current date. They
would take the coupon and deposit it, just like cash, into their bank account
or mail it in to the company to get a cheque, depending upon the terms and the
circumstances.
An Example of How the Bond
Coupon Would Work
If an investor wanted to buy a
£25,000 bond with a 30 year maturity and a 10% coupon, it would work like this:
He would send in the £25,000 from his savings account and get a £25,000
engraved bond certificate in exchange. After 30 years, he would be able to get
his whole £25,000 back from the issuing company (of course, he could always
sell it before then if he needed the money).
Every year, he’s entitled to receive
10% interest on the money he lent, or £2,500. If the company paid interest
semi-annually, he would likely have 60 coupons attached to his bond for £1,250
each. Every June 30th and December 31st, the investor would go down, clip the
proper coupon, send it in, and get their money.
Mr Bond says..... "In most cases, you will buy them through a
brokerage account and the interest payment will just show up as a deposit in
your account."
Today, bonds don’t work like this. In
most cases, you will buy them through a brokerage account and the interest
payment will just show up as a deposit in your account. In other cases, they
are held in “book entry”, which means that the company records your ownership
in a computer program and mails the coupon payment to you when it’s due – often
electronically deposited into the bond
holder’s bank account. Although the practice is now defunct, the terminology
stuck and interest payments on bonds will forever be known as coupons.
Investing in Bonds
Retail bonds with more than five
years to maturity can be put into Self Invested Personal Pension (SIPP)
accounts or Individual Savings Accounts (ISAs) with the attendant tax
efficiencies. The key point is that they can be bought or sold in very small
amounts; traditionally, corporate bonds have only really been available to big
institutional investors due to the large sums of money needed to invest,
however companies are offering corporate bonds to high street savers with a
typical minimum investment of just
£2,000. And the bonds' competitive coupon rates have unsurprisingly proved
incredibly popular among savers struggling with lower than ever interest rates
and increasing inflation.
Mr Bond says..... "They are very different to a savings bond offered
at a bank, they are what is called a ‘corporate bond’. What you see in your
bank is actually a fixed rate deposit."
Retail bonds are very different to a
savings bond offered at a bank, they are a ‘corporate bond’ rather than the fixed rate
deposit on the high street.
Retail bonds are highly regulated and
have to comply with a number of European directives and have to be sold through
regulated and authorised networks.
Familiar high street names, like
Tesco, John Lewis and National Grid, have all recently launched corporate bonds
aimed at retail investors.
.jpg)
In Summary
Private investors loan companies
money by buying their 'retail bonds'.
The minimum amount starts at a very
low level - sometimes as little as £2,000 and usually in batches of £100;
companies use the money raised to grow or to fund their business objectives.
Investors earn interest on the bonds
while they hold them. The bonds run out or 'mature' on a fixed date in the
future when all being well you get your money back.
The London Stock Exchange runs a
retail bond market – the Order Book for Retail Bonds (ORB) which allows you to
buy and sell bonds before the maturity date.
You can make some money on them early
if they are trading higher than the initial offer price (above par) - but you
might lose money if you sell when they are trading lower (below par).
Retail bonds are specifically
targeted at small investors and are separate from the far larger corporate bond
market dominated by institutions.
Other more niche bonds have been
issued by so-called 'passion brands', like boutique hotel firm Mr and Mrs Smith
and healthy fast-food chain Leon Restaurants. These ‘loyalty bonds’ are not
tradeable on the bond market but can offer higher returns, especially if you
are prepared to accept them in the form of vouchers instead of interest. One
earlier issuer, Hotel Chocolat, even pays out in boxes of chocolate.
Purchasing a retail bond gives an investor exposure to one
type of investment product in a single company.
Most would agree that holding a range of asset types in a
diverse number of industry sectors is the way to mitigate risk and maximise
upside opportunity and the use of retail bonds in a balanced portfolio, and
this is discussed elsewhere on this micro site.
As ever an investor should always take advice at an
appropriate level before purchasing retail bonds.
Are Retail Bonds Risky?
There are inherent risks in any investment, and retail bonds
are no exception.
The ultimate risk is that the issuing company should fail,
and with no protection from the Financial Services Compensation Scheme (FOS) at
the very best an investor could wait a very long time to recover some, or all, of
their investment, and at the worst could lose it all.
Having said that, riskier than
what? A retail bond is not riskier than equity, so if there was a problem and
the company was wound up, bond holders take preference over equities holders in
event of pay-out so it’s obviously a lower risk.
A canny investor will make sure
that he understands the precise nature of a retail bond into which he makes an
investment as different bonds carry different risks:
- Is the issuer a company I have
heard of?
- Do I understand the long-term
business plan of the company in which I am investing?
- Is the sector in which the issuer
operates one that looks attractive in the short to medium term?
- Are there any obvious threats to,
or weaknesses in the company’s proposition?
- Would I be prepared to lose all
of the money I am investing if my judgement proves wrong?
- Is the bond or the issuer rated?
- Is the loan secured against the
assets of the company?
- Is the loan I am making ‘senior’
or ‘subordinated’ debt?
- Have I read all of the terms and
conditions attached to the issue?
- Do I feel comfortable with
holding this debt security as an element of my financial future?
- If things do not go according to
plan will there be sufficient liquidity in the secondary market to allow me to
sell my holding?
- Do I have the right level of
financial literacy and sufficient information to make an informed investment
decision?
Caveat Emptor
The key to any investment is to
know what you are buying – upside potential and downside risk, a little
research can save a whole lot of regret.
Retail Bond Expert allows an
investor – individual or adviser – to access all information germane to a
particular bond issue and thereby make an informed investment decision.
Because retail bonds are traded
on a regulated stock exchange, namely the London Stock Exchange on a special
platform set up for investors so that they have transparency, you can see the price and you have insurance
of execution if you want to trade them during market hours. It is called ORB
(The Order Book for Retail Bonds) Launched in
2010 it is an electronic trading platform offering investors a cost effective,
transparent and efficient mechanism.
Remember though retail bonds
don’t have financial services compensation scheme attached to them so it is
important to read all documents carefully.
New issues can be found on the
website www.londonstockexchange.com as well as on the New Issues section of Retail Bond Expert.
.