Investing In Retail Bonds
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.
“(bonds) 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.
“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 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 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.
Bonds’ competitive coupon rates have unsurprisingly proved incredibly popular among savers struggling with lower than ever interest rates and increasing inflation.
“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 account is actually a fixed rated 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 launched corporate bonds aimed at retail investors.
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?
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.
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.