Savers are now in the unfortunate position where even if they can lock their money away for four years, they won't get more than 3 per cent interest. So the prospect of lending money to a company via a mini-bond for a similar period and getting double that amount is tempting.
The number of mini-bonds being launched in recent months is staggering. New research from Capita Registrars shows that the market for mini-bonds is set to grow from under £90 million last year to £1 billion by the end of 2013. But financial advisers are warning that although these products may seem attractive to income investors, they should be viewed with caution.
A mini-bond is an investment opportunity offered by companies to private investors, where investors lend money to a well-known organisation, such as a retailer, for a fixed period. In return, they benefit from cash interest and often additional benefits such as rewards associated with the company. Mini-bonds are unlisted products, meaning they cannot be traded and are not to be confused with retail bonds, corporate bonds and gilts which can be bought and sold on the London Stock Exchange.
Recent mini-bond issues are proving popular because investors are tempted by the often higher interest rates. This is because mini-bonds remove the margin from a bank - if savers deposit cash at a bank, it will pay one rate of interest and lend the money to its borrowers at a higher rate, keeping the profit for itself. Investors can benefit by cutting out the middleman.
Examples of recent issues include Nuffield Health unveiling a five-year bond paying 6 per cent, just weeks after The Jockey Club unveiled a similar bond for income-hungry investors. Companies that have previously launched mini-bonds include John Lewis and King of Shaves.
Mini-bonds are paying higher rates than bank accounts precisely because they do contain an element of risk - essentially the risk that the company could go out of business. So are they paying you enough to take that risk?
Before buying you need to check out the exact risks, including any protection on offer, the liquidity - how you access your money in an emergency, and any tax advantages that do or don't apply.
Customers may be inclined to invest as they have confidence in the company. However, investing in a single company is a high-risk approach. Even supposedly strong and secure companies can get into financial difficulties and investors in individual bonds cannot fall back on the Financial Services Compensation Scheme if the company defaults.
This lack of deposit protection means unlike savings accounts, mini-bonds have a risk of loss, so investors should focus on the most respectable names.
The fact that mini-bonds are not listed is a major disadvantage - it means that you can't trade in your investment if you need your money in an emergency.
It may mean that a bond is not eligible for inclusion in a tax-efficient individual savings account. Mini- bonds are taxed at the basic rate, currently 20 per cent on all cash interest to bondholders. The headline yield on the Nuffield Bond is 6 per cent for a basic rate taxpayer, but the net yield would be 4.8 per cent, and for a higher rate taxpayer the net yield would be 3.6 per cent, so in many instances it is not that attractive compared to the tax-free rate.
Vouchers, loyalty points and free products are often offered as added incentives over the cash return to customers when they sign up to a bond. While these can boost the return, serious investors may prefer the guarantee of cash.
A big downside is the lack of capital growth. Although you should get your capital back on maturity after the term of investment has finished, as with many investments you could lose out to inflation.
So you're basically buying into an investment that doesn't give you a great deal more than you could get in the bank, but has much higher risks. When looking at any investment, it is important to consider the alternatives to give your decision to invest in a wider context.
So what could you buy instead? Here are three ideas:
Cash Isa: Virgin Money Fixed Rate Cash E-ISA Issue 42 is offering an AER of 3.0 per cent on a fixed term until 24 May 2018.
Strategic bond fund: Legal & General Dynamic Bond fund (ISIN GB00B1TWMM97) has a yield of 4.5 per cent and is a member of the IC Top 100 Funds.
Exchange-traded fund: iShares Markit iBoxx £ Corporate Bond 1-5 (IS15) has a dividend yield of 3.40 per cent.
