As the alternative finance industry for small and medium-sized enterprises booms in the UK, the concept of the mini-bond is rapidly growing in the sector. These are relatively small bond offerings made by companies to the general public, generally through crowdfunding platforms.
In the same way as a conventional bond, mini-bonds are effectively a long-term loan to a business of between three to five years. They earn the owner a coupon interest payment with a bullet repayment of the principal at the end date of the bond.
The concept of the retail bond has been around for some time, and mini-bonds share many of the same features. These include the repayment structure, the fact they are non-convertible and that they are not protected under the Financial Services Compensation Scheme.
However, mini-bonds differ in a number of key ways, primarily in that they are not listed on the London Stock Exchange and are non-transferable and therefore lack the relative liquidity of retail bonds. Being unlisted means the regulation around them is a lot less stringent and information provided to investors is less thorough, often focusing on the concept and vision for the business rather than hard economics. The borrowers often tend to be less established companies without the track record of those in the traditional retail bond sector, which again increases the risk.
Why then, with these obvious drawbacks, is this sector growing? Part of the answer may be in the clever way mini-bonds are being marketed to the public. Mini-bond offerings tend to be from businesses in a sector that most people can readily understand, offer a return that seems attractive in this low interest rate environment and – just for a bit of added glamour – often yield enhancement based on the product being offered by the borrowing company.
Look at the table to see some examples of the mini-bonds that have been issued in recent years and the proposed return to investors.
The main concern that has been raised with mini-bonds is whether those investing fully appreciate the risk they are undertaking. Earlier this year the FCA highlighted that these investments were illiquid, high-risk and that it was not being made clear to investors that their capital was at risk without the protection of the FSCS. They also highlighted the differences between mini-bonds and retail bonds and the fact that investors should not be misled into confusing the two.
Recently, there has also been a high-profile failure in the sector. The Australian firm, CBD Energy, issued £7.5m of so-called ‘Secured Energy Bonds’ in October 2013, only to announce the failure of the parent company less than 15 months later, with bond holders losing all their capital. Despite investors having a minimum investment of £2,000 in this issue, it seemingly has not deterred companies or investors from continuing to grow this market. However, the majority of issues now tend to be in retail and food sectors, something much more easily understood by retail investors.
How can an investor assess whether the return being offered by a mini-bond is commensurate with the risk being taken? One possible comparison is with the crowdfunded business loans offered through platforms such as Funding Circle. Here, loans to businesses are comparable in that they are also unsecured and over terms of up to five years. They differ in that the return is always only in cash, the repayment structure includes part principal as well as interest with every monthly repayment, and – crucially – there is a secondary market where you can exit positions, if required.
These seemingly lower risk investments to companies with established trading histories and a track record of profitability vary in their returns from 7 per cent to 13 per cent. This is based on how they are credit scored by the independent Funding Circle underwriters. With most mini-bonds returning just 6 per cent to 8 per cent (in cash terms) they would begin to look expensive by comparison, even before one considers the extra risks as outlined above in this proposition.
The advantages to the borrowers though are clear: funds are cheap, the cash flow profile is benign, regulation is light and it is a chance to engage with potential customers, binding them into your business, like no other form of advertising can do. Many investors clearly seem comfortable with this arrangement too and continue to be happy to invest. It may be that the burrito or coffee tastes that bit better when you can share it with a friend and say: ‘I helped fund this business’.
It seems that, much like the wider crowdfunding market itself, as long as there are no further high-profile failures, this mutually beneficial relationship is set to continue to grow.
Sean O’Farrell is managing director of Choice Loans
Key points
Mini-bonds are effectively a long-term loan to a business of between three to five years.
Mini-bond offerings tend to be from businesses in a sector that most people can readily understand.
These investments to companies with established trading histories and a track record of profitability vary in their returns from 7 per cent to 13 per cent.
