Should you invest in mini bonds?

They are being touted as the next great investment opportunity. Mini bonds are the latest craze to hit the UK and have caused great excitement at a time when returns from traditional asset classes are pretty lacklustre.

On the face of it, they are very enticing. In exchange for lending money to exciting companies that are operating below many investors' radars, you can enjoy a decent return as well as get your money back on an agreed future date.

Then there are the incentives. Some mini bonds pay their returns in unusual ways with everything from chocolate to vouchers entitling the firm's backers to free food and drink. In a typically staid investment world, such extras can seem fun.

However, critics warn these products must come with health warnings attached as they are not subject to the same rigorous regulation as 'similar' products, nor do investors have the security blanket of the Financial Services Compensation Scheme if the company goes into administration.

So how do mini bonds work and should you consider them?

Mini bonds versus corporate and retail bonds

The origins of these intriguing products lie in the credit crunch of six years ago, since when small companies have found it difficult to secure bank finance, says Geoff Penrice, a financial adviser with Astute Financial Management. One solution has been to offer mini bonds direct to the public.

"These bonds are being issued by very small companies, which makes them higher risk than investment-grade or even high-yield bonds," he says. "However, investors willing to take the risk can get a yield of 10% as opposed to 1% or 2% from cash held on deposit."

In some ways, mini bonds work similarly to traditional bonds in as much as they're IOUs issued by companies that are sold to investors in return for regular interest payments and the value of their investment returned in the future.

Typically, individuals would access corporate bonds through specialist funds run by a manager who would invest in a number of different companies. As well as the benefit of having an expert making all the calls on your behalf, this approach also means you spread the amount of risk taken.

The value of these funds, however, depends on their individual holdings as well as the influence of the wider market's views on what is likely to happen with interest rates. In addition, investors will have to pay fees to the fund managers that will detract from the returns enjoyed.

Mini bonds are also broadly similar in concept to retail bonds that have been growing in popularity since the London Stock Exchange launched a market for them in February 2010, called the Order Book for Retail Bonds. Its aim was to encourage more firms to go direct to personal investors.

However, there are stark differences. Firstly, mini bonds are not traded so must be held to maturity, nor are they subject to the same intense scrutiny as retail bonds, which will be examined by legal and financial experts and a distributing stockbroker before becoming available.

Success stories

Even so, there have already been some notable mini-bond success stories. River Cottage, the restaurant and food business, made famous by TV chef and co-founder Hugh Fearnley-Whittingstall, raised £1 million on crowdfunding platform CrowdCube, attracting 283 investors in less than 36 hours.

A string of other companies have also launched bonds and paid returns in quirky ways. Hotel Chocolat, for example, recently offered two types of bonds as part of its bid to raise £10 million for a development programme to grow the company's presence across the UK and overseas.

Its Hotel Chocolat Bond pledged to pay a gross annual return of 7.25% in the form of a card that could be used to pay for products at the company's shops and restaurants, while the 7.33% return from its Tasting Club Bond will be paid in monthly chocolate box selections.

Elsewhere, the Jockey Club offered a Racecourse Bond whose 7.75% gross annual interest was split between 4.75% cash and 3% in racing rewards – points that could be redeemed for tickets, food, drink, hospitality and annual memberships at the group's 15 racecourses.

Then there was the so-called Burrito Bond issued by Chilango, a London-based chain of Mexican restaurants. All investors were offered two free burrito vouchers, while those who put in more than £10,000 could look forward to the prospect of free food for the duration of the bond.

According to Luke Lang, co-founder of CrowdCube (which facilitated the Burrito and River Cottage bonds), the combination of incentives and fundraising helps companies form strong bonds with their customers, which can only be good news for the businesses.

"It's a mechanism for creating and rewarding loyal customers," he says. "One of the key reasons for a company to issue a mini bond is to engage with customers and turn them into real stakeholders in the business. They're trying to get their patrons more involved."

However, doubts remain about the financial risk. The fact mini bonds are often issued by smaller companies in need of capital means there is clearly a greater chance of financial risk and default, points out Penrice. As they are not listed on the London Stock Exchange, they are also subject to far less independent analysis.

"Dealing with much smaller companies means that there is less financial disclosure, so it is harder to accurately see what the company's finances are really like," he says. "Mini bonds are also unsecured, so the bondholder is behind any secured debt holder should things
go wrong."

While it's easy to see the attraction for both investors looking for opportunities to make money and for companies that are desperate to raise finance, mini bonds must come with caveats, agrees Patrick Connolly, a certified financial planner at Chase de Vere.

"With interest rates remaining at historic lows, it isn't surprising that many people are crying out for competitive rates of income where they perceive that they aren't putting their underlying capital at undue risk," he says. "As a result, products such as mini bonds are proving incredibly popular."

Don't underestimate the risks

While this is fine for those who understand and accept the additional risks of mini bonds and diversify their investments over a range of bond products, he says there is a fear that people will underestimate the risks, especially if companies they trust offer the bonds.

"They are used by traditional bank and building society cash savers who have become frustrated with the miserly interest rates on offer," he says. "The returns on bonds appear competitive but it would be a mistake to compare their rates directly with those from savings accounts."

Before investing, you must understand the risks of relying on just one company or organisation to pay you back, he points out. "Investing in a single company, whether that is buying shares or bonds, is a high-risk approach, especially if the money represents a significant proportion of your overall investments," he explains.

"We have seen how even supposedly strong and secure companies, such as the high street banks, can get into financial difficulties."

Mini bonds are part of the so-called UK alternative finance market, which is not only helping to meet the capital requirements of businesses but the fundraising requirements of civic projects and social causes.

Generally, these so-called crowdfunding activities work by enticing a large number of people to each contribute a relatively small amount of money – thus enabling targets to be reached without finding one main benefactor – which is loaned to a business.

While still relatively small, it is on the rise and grew by a staggering 91% from £492 million in 2012 to £939 million in 2013, according to The Rise of Future Finance: The UK Alternative Finance Benchmarking Report by Nesta, the University of California and the University of Cambridge.

The study discovered that more than 647,000 projects, individuals or business financing campaigns were fully funded through alternative finance intermediaries. When compared to 2011 and 2012, in which the figures were around 448,000 and 503,000, respectively, it shows clear growth.

"Taking out the donation-based crowdfunding and peer-to-peer fundraising for charitable causes, the UK alternative finance industry still contributed more than £955 million worth of personal and business finance to the UK economy from 2011 to 2013," it stated.

It's not a trend that's likely to slow any time soon."Based on the average growth rates between 2011 and 2013, we can cautiously predict that the UK alternative finance market will grow to £1.6 billion next year and provide £840 million worth of business finance for start-ups and SMEs in 2014," it concluded.

Safeguarding investors

The popularity of crowdfunding-type investments has led the Financial Conduct Authority (FCA) to introduce safeguards that will have an impact on mini bonds – including the restriction that novice investors can only invest 10% of their readily investable assets.

An FCA spokesman said it was important that the safeguards, which are due to be in place later this year, were put in place because mini bonds were 'non-readily realisable securities' that were difficult to sell on or cash in.

"As important as the safeguards we are putting in place is the requirement that consumers are given clear, fair information, which isn't misleading," he added.