What is a Retail Bond?

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What is a Retail Bond?

A Bond is simply an 'IOU' in which an investor agrees to loan money to an individual, company or government in exchange for a predetermined interest rate.

There will come a time when most companies will wish to raise capital to fund any one of a number of business objectives which could include expansion, diversification or acquisition.

Alternatively, a business could seek to change its debt structure to either pay off more expensive loans, or reduce its dependence upon, for example, bank finance.

In such circumstances a range of options exist to the Finance Director which may include 'equity financing' - the issuing of additional shares via a rights issue or the issuing of 'preference' shares - or 'debt financing' via the issue of a whole range of bonds, debentures, deposits, notes or commercial paper.

These products are collectively known as 'debt securities' and differ according to term to maturity and other characteristics.

Additional options open to a potential issuer of debt securities include retaining profits within a business or traditional sources of borrowing; a balanced strategy would typically include a combination of a number of these techniques.

For the sake of differentiation, corporate bonds are those issued by a company whereas gilt-edged securities - 'gilts' - are bonds issued by a government.

Mr Bond says... "Corporate bonds are those issued by a company whereas gilt-edged securities - 'gilts' - are bonds issued by a government."

The current difficulty that companies, and particularly SMEs, are experiencing in securing loans from banks highlights the attraction of achieving a balance in terms of a company's borrowing in order to avoid over-dependence upon a single source.

How it works

When an investor - an individual, a pension fund or mutual fund agrees to loan money to a company, it does so at an agreed rate of interest.

The company pledges to repay the sum it borrows on an agreed date - the 'maturity' of the bond - and to pay interest to the investor at an agreed rate - the 'coupon' - either annually or biannually, for the duration of the loan.

Because the investor knows what rate of interest he will achieve, these are often known as fixed-income investments.

The rate that a company, or indeed a state, needs to pay to achieve borrowing is based upon its financial strength and stability and the risk that is inherent within its business; as with most investments, the greater the risk, the greater the return, so it is absolutely vital that a potential 'lender' (investor) understands as much as he can about an individual investment before taking the plunge.

Because of the very large minimum investment previously required, corporate bonds have traditionally really only been accessible to institutional investors and the preserve of pension funds and mutual funds.

However, in February 2010 the London Stock Exchange (LSE) launched the Order Book for Retail Bonds (ORB) with the objective of making a new generation of retail bonds accessible to the retail investor and providing liquidity in the secondary market for those that did not wish to hold the investment to maturity.

The ORB initiative

Fixed-income markets across Europe are very strong, and the LSE has high hopes that the ORB will mirror this success. By way of context, £3.5 billion has been raised on ORB to date, whereas Borsa Italiana's MOT Market trades up to €5 billion a day.

The UK Government has supported the ORB initiative which has manifested itself in the fact that retail bonds do not attract stamp duty and in theory a minimum investment of £1 can be made.

In a typical relationship the borrower or 'issuer' will appoint a lead manager to structure each offer and then promote it to potential purchasers - either individuals or wealth managers.

"Bonds are issued at ‘par’ of 100, equivalent to the value of the loan at maturity, and may trade at a discount or premium to this figure in the secondary market in response to a number of factors including fluctuating interest rates, the relative strength of the issuer and demand for the bond"

The offer will customarily be open for two weeks and made available via a network of authorised distributors, offering a range of discretionary, advisory and execution only services. At the end of the offer period, the lead manager will collate the orders that have been placed via the distributors and 'settle' the issue effectively allocating bonds to those that have applied.

Bonds are issued at ‘par’ of 100, equivalent to the value of the loan at maturity, and may trade at a discount or premium to this figure in the secondary market in response to a number of factors including fluctuating interest rates, the relative strength of the issuer and demand for the bond.

Clearly the price that a bond trades at affects the value of the coupon that is paid – a 5% coupon paid on a bond issued at par will not represent 5% if the bond trades at 103 – so investors are advised to consider the "running yield", which is a snapshot of the current price of the bond compared with the interest paid, and the "gross redemption yield", which shows you how much you'll earn if you hold it to maturity.

With initial launches coming from the financial services sector with issuers such as Tesco Personal Finance, Lloyds TSB and Provident Financial Group, subsequent offers have come from a diverse range of sectors such as oil with EnQuest and a range of property companies including Primary Health Properties, CLS Holdings and St Modwen Group; the LSE itself raised £300 million in October 2012 and proved the strength of its franchise by doing so at a coupon of less than 5% - a level that is considered a psychological threshold.

Education and Information

Throughout this microsite Retail Bond Expert aims to provide education and information to those considering the purchase of retail bonds in their portfolio, or greater understanding to those who may have had retail bonds purchased on their behalf.

Investors should always ensure that they fully understand the structure and inherent risks attached to any investment they may consider and should take advice appropriate to their experience and knowledge of investments.

Greater insight and context into the retail bond sector can be gleaned from the commentary section of this site with expert opinion from investors, fixed-income professionals and industry commentators

Mr Bond says... "Investors should always ensure that they fully understand the structure and inherent risks attached to any investment they may consider and should take advice appropriate to their experience and knowledge of investments.."

Expanded upon elsewhere, there are a number of key factors to be considered regarding retail bonds: Firstly, as with any investment, retail bonds expose the purchaser to an element of risk, and in the extreme instance of an issuer going bust, some or all of an investment into bonds in the business could be lost.

A would be purchaser should look at the historical performance of the issuer, the prospects for the market in which it operates and its long term business plan.

Equally important is to understand the precise nature of the bond that is on offer - the terms loyalty bonds, private placings, cash bonds and mini-bonds are being used interchangeably, and increasingly collectively described as ‘retail bonds’ despite the fact that they may vary greatly in terms of their debt structure, protections and risk profiles (See ‘Caveat Emptor – Mr Bond Urges Caution When Purchasing Retail Bonds’ - Retail Bond Expert 7th June 2013)

A further consideration is whether or not a bond or its issuer is rated – there is currently no industry standard to allow the objective comparison of retail bonds. Retail Bond Expert campaigns for the introduction of set criteria and standardised key information documents, and is heartened by a recent announcement by issuer group ORBIG that paves the way for a ‘traffic light’ system to aid comparison (‘ORBIG Predicts Green Light for Independent Ratings’ – Retail Bond Expert 24th June 2013).

Secured or unsecured?

Retail Bond Expert produces a micro site such as this in support of each retail bond launch in an identical format to allow users to become familiar with the supporting documentation that is available – would be investors should ensure that they have read the prospectus, terms and conditions and key information documents before committing to a purchase.

One vitally important piece of information, and one that allows like-for-like comparison, is whether or not the loan is secured against the assets of the issuing company, and where the bond sits in terms of the overall debt structure of the business; whilst loans secured against tangible assets would seem the most attractive, some that are unsecured may be contractually "senior" to other unsecured debt meaning their holders would have a priority in a bankruptcy of the issuer. Debt that is not senior is described as "subordinated".

Whilst not as dramatic as insolvency, the recent restructuring at Co-op Bank highlights the need for diligence when considering an investment; up to 7,000 investors, many pensioners, in the bank’s Permanent Interest Bearing Shares (PIBS – which share many characteristics with retail bonds) suffered a dramatic reduction in income and capital loss as the small print on the product allowed the issuer to convert them to shares as part of its restructuring following a bailout. (‘CO-OP Bank Bailout Confirms the Need for Caution’ - Retail Bond Expert 19th June 2013)

If the worst were to happen and the issuer was to go bust, there is no protection available for investors from the Financial Services Compensation Scheme (FSCS) (‘Government Protection for Retail Bond Investors?’ – Retail Bond Expert 23rd January 2013)

The use of retail bonds as part of an investment strategy is considered on this site, and a key feature of retail bonds is that by being typically offered for seven years duration, they can be held within tax-efficient SIPP and ISA wrappers subject to existing subscription limits.

As ever, would-be investors should always seek appropriate advice.

With interest rates historically low, and showing little sign of increasing, savers and investors have increasingly been attracted to the relatively high rates of return and capital protection offered by retail bonds and it is now estimated that around £3.4billion is invested in these products in the UK.

However, interest-starved savers and investors have increasingly been attracted to companies with which they may be less familiar and Retail Bond Expert is committed to delivering the information and education that both self-directed investors and advisers require to make informed investment decisions.

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