Investing Basics: What is a Retail Bond?

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 – writes Christian Leeming

 
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.

‘corporate bonds are those issued by a company whereas gilt-edged securities – ‘gilts’ – are bonds issued by a government’

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 the 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 had high hopes that the ORB will mirror this success. By way of context, £3.5 billion was raised in the first couple of years of operation of ORB, whereas Borsa Italiana’s MOT Market trades up to €5 billion a day.

The UK Government supported the ORB initiative which 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’

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.
 

 
Initial launches came from the financial services sector with issuers such as Tesco Personal Finance, Lloyds TSB and Provident Financial Group, with subsequent offers 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.

Retail bonds were extremely popular with those seeking a reliable source of income, to the extent that in a number of instances the offer was pulled after just a couple of days, with investors waiting nervously to see what proportion of their order had been fulfilled.

However, issusance became rare, and no few scandals whereby issuers of far riskier ‘mini bonds’ pedalled them as an alternativeto retail bonds, with the inevitable consequences.
 

Education and Information

 
Retail Bond Expert (www.retailbondexpert.com) provides 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’

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

www.retailbondexpert.com

January 2014