Join our community of smart investors

Mini-bonds under the microscope

The credit crunch has spawned a whole new asset class in mini-bonds, but despite the
November 29, 2013

As Investors Chronicle's point man for fixed-income investments, I've spent most of the autumn fielding at least two calls a week from financial PRs about mini-bonds.

Indeed, there has been a flurry of issuance over the past few months of these instruments, and our gut reaction has been one of general wariness - as Moira O'Neill wrote in May 2013, mini-bonds are really a form of direct loan and differ substantially from corporate bonds in that, unlike more traditional retail and corporate bonds, they cannot be traded, are prohibited from being held in individual savings accounts (Isas), unlike Orb bonds which can if they have a yield to maturity at more than five years (both can usually be held in Sipps), and are a non-transferrable asset. As such, the name 'mini-bond' is a probably a misnomer, but the description has nevertheless stuck.

Yet, despite our misgivings, the emergence of mini-bonds is an increasingly difficult trend to ignore - some are even advertised in Investors Chronicle from time to time (although are not, as a matter of course, endorsed by us). The rise of the market reflects the generally poor bank rates that small savers receive, as well as a funding environment that has made it hard for small- and medium-sized businesses to raise smaller lumps of capital at a reasonable cost. However, what has also become obvious is that the sector as a whole has escaped the kind of in-depth analysis that is normal for both the equity and corporate bond market. That's a concern, as a number of market insiders have revealed to us some real worries about how the mini-bond has developed.

 

Regulatory shortfall

The misunderstanding over what constitutes a bond is a general problem - especially since some mini-bonds have been marketed as retail bonds, such as the £2.5m mini-bond issued by bedmaker Warren Evans. Richard Tice, chairman of ORBIG, the group that represents Orb bond issuers, believes that the distinction between mini-bonds and traded retail bonds should be made much clearer, and is unsurprisingly forthright about how the mini-bond market should be regulated.

He notes the disparity between the rules governing issuance, pointing out that in the case of regular bonds, marketing and information material has to be thoroughly vetted by the UK Listings Authority and the Financial Conduct Authority and all risks disclosed. He said that the same should apply to the material sent out by mini-bond issuers, as one of the features of mini-bonds is that companies are issuing them precisely because the current regulatory requirements are far easier to meet. "The prospectus does not have to be vetted by the UKLA and there is a serious gap in regulation between Orb bonds that have to meet demanding requirements and issues that are actually direct loans to small companies," he said. "There will be a hiccup," he added, expressing concern that should any mini-bonds run into trouble, it could affect sentiment towards the much more robustly regulated retail bond market.

 

 

This argument was confirmed by Chris Searle, a corporate finance partner at accountant BDO, which has developed a niche in aiding the launch of mini-bonds. Mr Searle says that mini-bond marketing had no guidelines on what had to be published other than it had to be verified by a lawyer and that it was "clear, fair and not misleading", according to the Financial Representations Act. He said that in his personal experience, BDO had rejected launch applications from up to 15 companies since the first mini-bonds were issued.

The other problem with mini-bonds is a lack of clarity around the companies that issue them. Unlike most traded retail bonds, mini-bonds are generally issued by smaller private companies whose accounting is far more opaque. That, of course, makes it significantly harder to assess the credit risk investors are being asked to take on in return for yield. And while analysing a company's equity does not work on exactly the same principle as analysing its creditworthiness, a number of boutique research houses have sprung up to deliver credit analysis of the retail bond market - nothing similar is proposed for mini-bonds.

To plug this information gap we've tried to analyse several companies that have recently issued, or are in the process of issuing a selection of mini-bonds, in a way that mimics our coverage of the equity and corporate bond market.

 

 

Windy logic…

The renewable energy sector has been the most active issuer of mini-bonds since soon after the market opened. This offers investors a certain ease of comparability as there are similar listed and unlisted renewables companies out there with a utility-like structure.

Ecotricity is a notable example of an unlisted company that has in the past couple of years issued two current mini-bonds, paying out coupons of 7.5 per cent and 6.5 per cent, respectively, and it plans a third issue at some point. The funding and building of windfarms, which is Ecotricity's speciality, is never going to be an easy topic in the UK countryside, but whatever your view of the subsidies that renewable energy receives, Ecotricity at least backs its mini-bonds with the entirety of its balance sheet, which consists of tangible windfarm projects.

That is impressive given that its founder, Dale Vince, started the company after finding a way to power his caravan with a windmill. For a capital-intensive non-listed entity such as Ecotricity, issuing mini-bonds instead of taking on more bank debt has a kind of natural logic. If it can deliver on its promises, then investors will get their money back. However, with Ecotricity not returning press calls, ordinary investors could find getting access to the company's accounts difficult.

 

 

What value Ecotricity would command were it a listed company is hard to gauge, but another renewable energy concern, Good Energy (GOOD), is a fully paid up member of the Alternative Investment Market (Aim). The shares have performed well since listing at around 100p last year and currently stand at 240p. In such circumstances, access to capital should be less problematic than at Ecotricity, but Good Energy is also in the process of marketing a £5m mini-bond paying a coupon of 7.25 per cent a year.

It is obvious looking at its reports that Good Energy is financially stable but it clearly needs cash for expansion. Annual revenues are over £20m a year and the balance sheet is carrying current liabilities of £10.4m on top of total equity of £11.9m. Given that the company is a fully integrated utility company with something like 47,000 customers, regular cash flows should not be a problem, particularly when its new windfarm projects come on stream.

With that sort of tentatively respectable corporate profile, it seems odd that management would opt for issuing a mini-bond. In fairness, the company is open about the fact that the mini-bond is very junior unsecured debt as the majority of its assets are pledged against its senior bank debt. Sound companies have a perfect right to diversify their sources of funding, but in this case the better investment option might be to just buy the shares and hold them. They pay a small but growing dividend, you'll share in the capital growth and they can, as an Aim equity, now be held in an Isa.

 

Flying close to the sun…

The mini-bond issues we've looked at so far in the renewable sector are comparatively simple compared with the mini-bond that CBD Energy has been promoting around the City of London. The new mini-bond is not actually a CBD-issued instrument, but the result of a newly formed company called Secured Energy Bonds (SEB), with registered offices in Pinner High Street. This will issue a 6.5 per cent secured mini-bond with the goal of raising £7.5m to finance solar projects in the UK.

The idea behind the secured bond is that CBD will act as guarantor for the bonds, while at the same time having no prior claim on the assets of SEB ahead. In addition, there is a security trustee to protect the interests of bondholders. The problem is that CDB Energy is, to put it politely, in a restructuring phase that might compromise its role as guarantor to the SEB bonds. Its recent 2013 preliminary results, for example, revealed that the company had to restate its accounts back to 2010 after "mistakes" were discovered in the way it capitalised expenditure on projects. The restating of these had the effect of doubling its pre-tax losses in 2012 to Aus$37m (£20.8m).

 

 

In fairness, some of the problems were beyond CBD's control. For example, the Australian government reversed many of the environmental subsidies that underpinned investment in solar projects, which had the knock-on effect of scaring investors away from providing capital. In short, there were plenty of problems for new executive chairman Gerry McGowan to deal with. As part of the restructuring process, the company reached an agreement with Westinghouse to brand its operations with the Westinghouse banner, while at the same time it looked to delist in Australia and pop up again on Nasdaq as a way of accessing a new sources of capital.

The saga looks set to run for a while longer as the accounts for 2013, though showing considerably narrower pre-tax losses of $5.7m, also contained a warning that CBD's auditors were preparing to add an emphasis of matter to the final accounts related to the company's ability to continue as a going concern. At the time of writing, CBD missed a deadline on the 22 November to publish its full audited accounts, according to the information on the company's website.

The question, then, is how does this relate to the security of the bonds? The company argues that the mini-bond is a largely separate entity that is secured against its own assets. At the moment, these don’t exist as Secured Energy Bonds has yet to develop solar sites in the UK, so the only asset is currently the bondholders' own cash. In addition, the repayment of the capital is still ultimately subject to CBD's ability to refinance, sell or recapitalise the bonds.

 

 

Not all about returns…

In another context, the problems highlighted at CBD would be just another corporate hard luck story. Using the unfortunate CBD/SEB bond as an example, the 6.5 per cent coupon is only two percentage points more than the 4.5 per cent mini-bond that John Lewis issued in 2011. If SEB bonds were ever issued on the corporate market, they would certainly attract a much higher yield.

That highlights one of our main concerns with mini-bonds: that there will always be a disconnect between the levels of risk that investors are asked to take on mini-bonds and the level of income on offer. In fact, we believe the lower regulatory hurdles companies face when issuing mini-bonds means they are a lower-cost financing option, and investors should therefore enjoy a greater share of this saving. Interestingly, there is already a tradeable market for junior bonds in Germany, where smaller, high-risk companies have been offering coupons of up to 15 per cent for fully tradeable bonds on regional stock exchanges. Inevitably, there were some defaults within a short time, but the risks associated with such returns were made explicitly clear.

Perhaps, though, it may not be just about the income at the end of the year. Mini-bonds have a place in investment portfolios because they offer fans or consumers the opportunity to express their preferences or show their loyalty. For example, the Jockey Club's mini-bond comes with racing benefits as the racing institution redevelops its racecourses. Meanwhile, prospective offers for Warren Evans Beds and Nuffield Gyms have obvious consumer appeal - such was the popularity of the former offer that it hit its £2.5m target after just three weeks, while Nuffield raised £18.6m through its offer, substantially ahead of its £15m target with an average investment of £14,000 across 1,300 investors.

Certainly, there are also attractions to supporting growth businesses - although remember that you won't participate in that growth directly, and while you should get your capital back at the end of the mini-bond's life, it may have been eroded by inflation. That's at the riskier end of the investing spectrum, but so far there have been no high-profile mini-bond failures, and those that have expired - such as the mini-bonds issued by King of Shaves and Hotel Chocolat - have delivered their coupons and returned initial capital to investors. Some mini-bond issues also offer payment guarantees, but this is just a legal formulation to show that the trading company is responsible for payments and ultimate redemption, rather than the Plc set up to issue the mini-bond.

Indeed, as with anything that involves risking your money, caveat emptor is still the soundest advice to follow - because the main characteristic mini-bonds share with Orb bonds is that they are not protected by the government's Financial Services Compensation Scheme, which protects bank and broker deposits up to £85,000 and investments up to £50,000. And if you’re happy to lock up your capital, high interest savings accounts offer comparable yields when the effect of tax on the income you receive is taken into account - mini-bond yields are cited gross, so a higher rate taxpayer, for example, will only receive a net yield of 3.6 per cent on a gross yield of 6 per cent. In short, don't be beguiled by the prospect of high yields alone, especially as unregulated products have occasionally delivered nasty surprises.

 

Promoted mini-bonds

CompanyGross coupon (%)Term (years)Business activityPaymentCommentsOpen/closed
Ecotricity6.54Wind farm operatorSemi-annualGross coupon, 20% tax at sourceClosed
Ecotricity64Wind farm operatorSemi-annualGross coupon, 20% tax at sourceClosed
Good Energy7.254Eco-energy supplierSemi-annualInvested directly in infrastructureClosed
Jockey Club 7.755Racecourse operatorQuarterly3% of coupon in rewards pointsClosed
John Lewis 4.55RetailAnnual Additional 2% paid in vouchersClosed
Mr & Mrs Smith 7.54Boutique hotelsSemi-annual9.5% alternative in loyalty pointsClosed
Nuffield Gyms 65HealthcareAnnual Gross coupon, 20% tax at sourceClosed
SEB6.53Solar energyQuarterlySecured against SEB assets Open
Ocean Capital Industries6.53Corporate financeQuarterlyMay be suitable for SippsOpen
SmartWater 7.53Anti-crime productsSemi-annualMinimum £2,000 Open
Warren Evans 7.53BedmakerSemi-annualCoupons guaranteed Closed
Wind Prospects74Wind farm operatorSemi-annualPays 8 per cent for investments over £10,000Closed