Remember retail bonds?

Rather, the reason for this newfound caution stems from a niche corner within the fixed-income market; namely mini-bonds, and the scandal involving London Capital & Finance (LCF) – a now notorious hawker of the debt instruments, which collapsed into administration earlier this year.

Typically, investors buy bonds not for their capital appreciation, but to beat the rate of interest offered by savings accounts. LCF’s mini-bonds were marketed to meet this demand. In exchange for returns of up to 8 per cent a year, LCF sold bonds promising to reinvest the proceeds into hundreds of companies, and pass on the returns by way of interest payments. That didn’t happen, and more than 11,500 investors – some of whom believed the bonds were protected under the Financial Services Compensation Scheme – may have seen holdings worth £236m completely wiped out.

The Serious Fraud Office has since launched a criminal investigation, while the Financial Conduct Authority has appointed an independent review to establish whether the existing protections adequately protect retail purchasers of mini-bonds “from unacceptable levels of harm”.

While the extent of the damage remains to be seen, thousands of retail investors will have been left with the impression that bonds offer little downside protection. That would be a shame, because a big draw of fixed-income securities – and the other key reason investors buy them – is that they are less risky than shares.

However, like shares – but unlike many mini-bonds or peer-to-peer products – lots of bonds can be openly traded on the market. They also promise to pay a fixed level of annual interest and a 100 per cent return on the coupon price if held to maturity. For companies, bonds help to avoid shareholder dilution while providing a longer-term source of financing than banks might be prepared to offer.

Orb – missed opportunities

Unfortunately, ordinary savers have historically faced obstacles when accessing the corporate bond market, a fact that helps to explain why products such as mini-bonds – however dubiously structured, marketed or regulated – have garnered broad appeal. The reason is simple: the market for many corporate bonds requires high minimum investments, and aren’t sufficiently liquid for smaller investors.

One potential answer to this conundrum arrived in 2010, in the shape of the London Stock Exchange’s Order book of retail bonds, also known as the Orb. At present, it lists some 73 corporate and charity bonds for sale to retail investors.

A scan through this list reveals several interesting characteristics. The first is that these have been great deals for many of the bonds’ original investors. More than four-fifths of the bonds trade at a premium to par, and more than half above their ‘dirty price’ – that is, the price that reflects any interest that has accrued since the most recent coupon payment.

A second, related observation is that the best deals came at a very interesting period in debt capital markets, when interest rates were much higher and corporate credit was in thinner supply. The fact that Lehman Brothers is listed as the bookrunner or manager on many of the largest blue-chip offerings dates the market’s heyday. That there have been just five corporate issues since the start of 2018 tells you that most large companies have cheaper funding sources available elsewhere.

The third point to note is that the market provides relatively few opportunities to beat the risk- and tax-free annual interest rates currently on offer from cash individual savings accounts, as low as these returns can be. While the median current yield of all the bonds on Orb stands at 4.9 per cent, the average annual return falls to just 2.66 per cent if held to maturity.

To understand this dynamic, just look at Lloyds Banking’s (LLOY) 6.5 per cent coupon, which matures in 2040. At its current trading price of £169.80, its flat or current yield is 3.83 per cent, meaning that – on a crude calculation – the bond will need to be held for just over 18 years to merely cover the premium to par. Throw in inflation and tax on that interest, and the income benefits start to seem negligible.

Worth it? Many retail bonds look expensive

This might not be a problem for those investors who think that over the long term UK interest rates can only head into negative territory. On this basis, some may be content to shell out the 17.3 per cent premium to par commanded by HSBC’s 6.5 per cent notes maturing in 2023, in return for the promise of a 0.83 per cent annual return.

But securing even that miserable interest payment could be a challenge. At the time of going to press, LSE market data suggested the HSBC bond carries a £115.25 to £118.90 bid-offer spread, and has only been traded a handful of times since March. While that may not capture all off-market trades (some of which still require telephone calls placed to brokers or investment platforms), a lack of regular trading volume is a further reason for concern. Pay £118.90 for this bond, and the annualised return to maturity halves.

Pockets of value

All is not lost, however. For those investors willing to climb a little higher up the risk ladder, there are a handful of retail bonds that do not mature until at least 2021, possess credit ratings strong enough to trade at a premium to par, and still offer an annual return of at least 3 per cent if held to maturity.

These include blue-chip names such as Aviva and Ladbrokes, as well as smaller financial services groups Paragon Banking and Provident Financial, and a range of unsecured retail charity bonds.

The interest payments on offer aren’t stellar. But they could be a worthwhile trade off compared with the wide selection of UK-listed, blue-chip high-yield dividend stocks – even if one considers dividend income growth, and reinvesting dividends back into a company’s shares. The latter compounding effect, as this magazine has long championed, is a well-trodden path to long-term capital appreciation.

However, save for corporate default, future bond payments are almost always fixed. Dividend payments are not, and are often cut.

This year, the Henderson International Income Trust expects global corporate profits to surpass the 2018 record of £2.8 trillion. At the same time, dividend coverage has been declining, particularly among UK stocks. According to investment platform AJ Bell, FTSE 100 shares should yield an average 4.8 per cent in 2019, but will be covered just 1.63 times by profits, a 10-year low. Five years ago, those same dividends were covered twice over.

This trend cannot continue indefinitely, even if equity prices might continue to rise. As ever, for the income seeker, the trade-off is more or less risk.

The sharp end of Orb

Indeed, to some investors, bond buying is only ever a worthwhile activity if the returns can beat dividend yields. To beat the FTSE 100 or Orb averages, however, investors are left with the bonds of a rugby club that may have already breached its covenants, an oil producer that pays its interest by issuing more bonds unless oil rises above $65 a barrel, and an Indian film distributor trying to escape default. To us, the retail bonds of Wasps, EnQuest and Eros International carry too much risk to qualify for most retail investors’ portfolios. But the asset bases, capital structures and financing options of International Personal Finance and Provident Financial mean we would expect the doorstep lenders to maintain coupon payments for another four years.

High-risk, at a discount to par

For more on investing in retail bonds, the IC has a guide here https://www.investorschronicle.co.uk/content/download/27243/742422