A guide to mini bonds

Afraid of complicated investment products? Don't worry, these are mini! None of those pesky consumer protections or secondary markets, or other complicated bits that take time and concentration to wade through - on which more later.

On the other hand, they are interesting propositions. In many cases, they promise payouts set to beat what might be considered good returns in an equity fund. And if you are really into a certain product or hobby - horse racing, chocolate or boutique hotels, for example - they can be a pleasant way to play with one corner of your portfolio.

Easy access

Mini bonds are like the unruly younger brothers of relatively sensible retail bonds. Retail bonds give investors a direct path to corporate debt opportunities, freeing them from having to seek access via a corporate bond fund that buys wholesale.

Most of the institutional bonds issued by companies have minimum investment requirements in the hundreds of thousands of pounds, effectively ruling them out as individual holdings for everyday investors.

Retail bonds emerged to fill this gap in the corporate bond market. They usually require a minimum investment of between £100 and £1,000 and list on the London Stock Exchange's Order Book for Retail Bonds (ORB).

When we last wrote about retail bonds, we reported that although investor enthusiasm was high, issuance was slowing down. Only six companies had launched retail bonds in the year to June 2014, compared with 16 in the previous 12 months. That trend seems to have continued: only five retail bonds listed in the 12 months to 1 March 2015, compared with nine in the previous year.

The average issue size has also fallen, from £104 million in the 12 months to March 2014 to £80.2 million in the following year. This reduction in average size is partly due to one particularly small listing - the £11 million Retail Charity Bonds (RCB) - and the small bond pool. Excluding RCB, the average issue size was £94 million, still a slight drop.

Mini bonds are a more recent arrival. By foregoing trading on an exchange - and by paying part of the coupon in their own product in some cases - companies can avoid some of the costs of issuing a retail bond.

With the Bank of England now having held interest rates at rock-bottom levels for six years, Adrian Lowcock, head of investing at Axa Wealth, says the rise in mini bonds is a symptom of the hunt for income. “I think they often tried to appeal to savers looking for something more than cash, which was paying below-inflation rates,” he explains. “These bonds often looked like secure alternatives, [although] they are actually higher-risk alternatives.”

Twin trend

James Tomlins, manager of M&G's Global High Yield Bond fund and European High Yield Bond fund, adds that the popularity of mini bonds is the result of a confluence of factors: investors' continuing hunt for income has coincided with banks' greater reluctance to lend to higher-risk businesses.

Quirkier examples of mini bond issues include The Jockey Club's Racecourse bond, which pays 7.75% a year over five years, split between 4.75% cash and 3% in loyalty scheme points; the Hotel Chocolat bond, which lets investors choose between an annual return of 7.25% of in-store credit or 7.33% in the form of a monthly box of chocolates; and the Mr and Mrs Smith bond, in which investors choose between 7.5% a year for four years or 9.5% in points with the boutique hotel chain's loyalty scheme.

One bizarre example is the Chilango bond, paid out partly in burritos from Chilango restaurants.

“[The appeal of mini bonds] is a high fixed income, a capital return at the end of the bond's life, discounts and loyalty offerings for bondholders, and options to convert the bonds into payouts in goods and services,” says Lowcock. “You get to invest in a company you really like and are a customer of.”

Of course, there are drawbacks. The most obvious is the potential for capital loss: because mini bonds are usually issued by individual relatively small or new companies, they make quite risky investments. This is fine as long as you are happy to take on that risk, but it could be easy to find yourself with your eggs in too few baskets if you are relying on mini bonds for returns.

In addition, while retail bonds can be held in an Isa, mini bonds cannot. Both, however, can be held in a self-invested personal pension (Sipp).

However, Tomlins warns: “A lot of practices in this market fall far short of what we would expect from the institutional bond market. The level of disclosure you get is pretty limited. You can have a prospectus that is four or five pages long and very shiny, but pretty minimal in terms of financial information.”

In the balance

Lowcock adds that investors really should understand the business's balance sheet before investing, to get an idea of how likely the company is to succeed. Early 2015 saw the first mini bond default, when bonds issued by Secured Energy Bonds stopped paying interest, leaving investors wondering if they would ever see their money again.

Investors should also consider the fact that there is no secondary market for mini bonds. Once you buy a mini bond, you're stuck with it until the end of the bond's life, typically five or six years.

But there are two particularly important drawbacks to be aware of. The first is the lack of investor protection. Too often the company issuing the bond doesn't make clear exactly what assets investors are lending against, or where in the queue of clamouring creditors they will be if the company subsequently becomes insolvent.

Moreover, mini bonds can be bought back by the issuing company at parity before the term ends, perhaps if the company decides it no longer wants to pay out a coupon to investors or finds better financing elsewhere.

This may sound technical, but it's an important detail: with institutional bonds, in contrast, if the company wants to buy them back early, it has to pay a higher price. This ensures that investors will get a bit of an uplift, even if the bonds don't run to term, and that there are two ways to profit from investing.

Tomlins says this means that while bondholders share all the potential downside - losing their investment if a firm goes bust - they aren't guaranteed to enjoy all the potential upside.

The second drawback is what Tomlins calls a “disconnect” between the level of risk taken on by a mini bond investor and the potential returns. Even payouts approaching 10%, he says, would not be enough to convince an institutional bond fund to invest.

Considering that the companies involved are unproven start-ups, it would take payouts of three times that size to convince big-time investors to take on the risk entailed in investing in such companies.

However, he adds that there is a place for these high-risk investments if you can afford to lose your capital and don't mind living with that level of risk.

So who should invest in them?

“Loyal customers who know the business and business owners well and are willing to take the risk,” says Lowcock. “[They are] not suitable for [cautious] investors looking for an alternative to cash.”

However, considering that it has been persistent low interest rates that have contributed to the rise in popularity of mini bonds, one has to wonder if they are being bought by the right kind of investor, or if investors are perhaps taking on more risk than they realise in an effort to boost their income and beat inflation.

Sample mini bonds available

Rectory Homes Bond

A five-year fixed-term bond paying 6.25% gross a year issued by property developer Rectory Homes to fund building homes.

Wellesley Mini Bond

Available for three-, four- or five-year terms and paying 6, 6.5 and 7% gross respectively in biannual instalments, issued by peer-to-peer lender Wellesley & Co 0800 888 6001.

Retail bonds

At the time of going to press, no new retail bond issues were available on ORB. However, you can view all current listings by visiting ORB's website.

Mini bonds: for and against

High yields
Low minimum investment
Clever perks

Not Isa-able
Not transferable
High risk of default
Lack of transparency
Imbalanced downside and upside exposure
Lack of investor protection
Not covered by Financial Services Compensation Scheme

More about