BondsJul 17 2019

The pros and cons of mini-bonds

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
The pros and cons of mini-bonds

The high level of initial investment involved – as much as £1m in the case of FTSE 100 companies – means they are not suitable for individual investors to buy.

Depending on the risk involved, the borrower (the company) will pay the lender (the investor) a rate of interest.

The higher the risk of the company not paying back the loan, the higher the rate of interest.

This payment is called a coupon, and the interest rate is also referred to as the yield.

Key Points

  • Mini-bonds are a loan issued directly by the issuer to individual investors.
  • The 'Burrito Bond' raised £1m in a few days and the appeal is the higher rate of interest on offer.
  • Mini-bonds are considered high risk and are not subject to a lot of regulation or protected by the FSCS.

Bonds will have a set term and a maturity date on which the capital is repaid.

Large, established companies issue bonds through the stock market to raise money to pay for expansion, mergers and acquisitions, share buy-backs or dividends.

These bonds can then be traded on the Order book for Retail Bonds between institutional investors, such as fixed income fund managers.

How the stock market values them will change depending on the yield they offer, the current interest rate market and when the maturity date is.

What is a mini-bond?

Less-established companies too small to be of interest to institutional investors may issue what is known as a mini-bond to raise money.

This is a loan directly between the issuer and individual investor, and requires a far smaller initial investment.

Because they cannot be traded between third parties they are considered illiquid assets – you are locked in until the bond matures.

Mini-bonds often offer a higher rate of interest than corporate bonds – attractive in today’s market where income is hard to come by.

FTSE 100-listed telecoms firm Vodafone issued a corporate bond in 2017, which is due to mature in 2025, paying an annual interest rate of just 1.125 per cent.

You can get a little more interest if you invest in a company with a lower credit rating, meaning there is a slightly higher risk of default.

The iBoxx Investment Grade Sterling Corporate Bond index is paying out a 2.7 per cent yield – but that is before tax and fees, and inflation is running at 2 per cent, eroding the real rate of income.

But last October, Mexican fast food restaurant Chilango issued a mini-bond yielding 8 per cent.

Dubbed the ‘Burrito Bond’, the term was four years and required a minimum investment of four years.

The bond was so popular it raised £1m in just a few days.

One of the quirks of mini-bonds is they often come with added extras – the Burrito Bond, for example, offered investors free burritos and guacamole if they invested.

In 2015, Taylor Street Baristas café launched a ‘Coffee Bond’, which offered an 8 per cent cash return or 12 per cent in-store credit for free fresh grounds, pastries and lattes.

What are the risks?

But as all investors know, you rarely get more reward without taking on more risk.

Much like buying shares in an unquoted company versus buying shares in a FTSE 100 business, mini-bonds are considered far more risky than investing in a fixed income fund.

As mini-bonds are not traded on the stock market they are subject to significantly less regulation.

If the issuer goes under or faces financial difficulty there is no guarantee you will get your investment back.

And mini-bonds do not have to provide investors with financial statements in the same way an issuer of a corporate bond does.

So being sure of the financial health of the company you are lending money to is far trickier.

If clients change their mind and wants their money back before maturity, there is no way to do so – they have to stick it out.

And unlike cash bonds, issued by banks and building societies, an investment in a mini-bond is not protected by the Financial Services Compensation Scheme.

So if the company does go under, investors have little chance of recompense.

Earlier this month, property company Harewood Associates warned investors in its house-building mini-bond that it may not be able to repay the loan, and prior to that in January this year London Capital & Finance saw the regulator freeze mini-bond investors’ assets.

Last year, Square Pie, a restaurant group that began as a stall in London’s Spitalfields Market, went into administration, leaving more than 300 investors in its mini-bond high and dry.

And they are not the only ones – the list of failures is long.

The Financial Conduct Authority has launched an investigation into the LCF failure – addressing allegations that the mini-bonds were marketed as able to be held in an Isa and that they were regulated, where in fact only the company was, not the product. The investigation has since spawned a wider review of the sector conducted by the Treasury, looking into whether the current regulatory regime for mini-bonds is appropriate.

For investors trapped in the LCF mini-bonds, there may be good news. While the investments are not covered by the FSCS as standard, there may be grounds for a claim due if the company was found to have been giving misleading advice. There are 11,700 people with assets trapped in the mini-bonds, with a total invested of £237m.

Investors affected are being encouraged to fill out a questionnaire posted on the FSCS website to help determine whether there are grounds for compensation.

Should my clients invest?

As with all investing, it is a case of risk appetite.

Fixed income investing is designed to reduce risk in a portfolio and add ballast to volatile equity markets – mini-bonds definitely do not deliver on that front.

If your clients have well-diversified portfolio and are happy to invest in unregulated instruments for the chance of a high reward, then these may be for them.

But there are many examples of failures, and plenty of easier ways to earn free coffee and burritos.

Advisers who are being instructed to invest in mini-bonds on their client’s behalf, or facing questions about the viability of the alternative attractive-sounding income source, should ensure their clients are aware of the risks involved.

Emma Wall is head of investment analysis at Hargreaves Lansdown