Risky option could look attractive in current climate, says Jeff Salway
Crowdfunded bonds will become more appealing to income-hungry investors next week when they qualify for inclusion in Isas.
Returns from high yield bonds issued through crowdfunding platforms will be sheltered from tax on capital and income from 1 November, as they become part of the Innovative Finance Isa.
The risk levels means they will only be suitable for a minority of investors. But demand is expected to be robust as low interest rates and growing concerns over the outlook for dividends force income-seekers to consider alternatives.
The Innovative Finance Isa was launched in April to allow peer-to-peer (P2P) savings through platforms such as Zopa and RateSetter to be held in tax-free Isa wrappers for the first time.
Now the Innovative Finance Isa is being opened up to include bonds issued through crowdfunding platforms, where investors lend money to specific companies needing finance.
The idea is that ordinary investors get tax-efficient exposure to companies in return for higher interest rates than those offered on retail bonds. The loans are asset-backed, which means the borrower’s operational assets can be sold if it is otherwise unable to pay interest on the bonds.
The higher returns reflect the less mature status of the issuer, with crowdfunded bonds typically used by small firms that are more likely to default on their loans than more established companies.
Investors should remember that a high interest rate tells them the opportunity is a risky one, said David Thomson, chief investment officer at VWM Wealth in Glasgow. The risk is also asymmetric, Thomson pointed out.
“For example, if you own a share in theory your profit might be infinite while you can also lose all of your investment. With a loan you can still lose all your money but the maximum upside is just the interest,” he explained.
“This is ok when there is a good prospect of a) the interest being paid and b) getting your money back. It is not such an attractive deal when the risks of losing your money increase as there is no prospect of making better returns.”
There’s also the question of liquidity (the ease with which you can offload the investment). “Even if things are going as you expect it will be difficult to get your money back when you want as these investments will not be readily tradable,” said Thomson. “So you will have to be prepared to lock up your money for several years and not expect to get it back on demand.”
The appeal of crowdfunded bonds lies partly in their ability to offer investors access to projects they might have a personal interest in. A hydro power station project created on the River Lochy in Argyll by Nightjar Sustainable Power has raised £1.25 million from bonds issued through the Downing Crowd platform.
The Lochy Hydro plant has been operational since July, generating more electricity than expected in its first three months.
The funds raised through the crowdfunded bond, which pays five per cent fixed over one year, will support its ongoing development.
Julia Groves, head of crowdfunding at Downing, said: “Different types of crowdfunding often get lumped together as ‘extremely risky’ but crowd bonds are a simpler type of investment and, provided investors fully understand the relevant risks, they can offer attractive returns against a backdrop of record-low interest rates.
“We are immensely proud of our involvement with the Lochy Project to date and have some exciting prospects in the wider Scottish market in the pipeline too.”
Investors should avoid letting the enhanced tax status of crowdfunding bonds from wagging the investment dog, however. It’s important to note too that investors are not covered by the Financial Services Compensation Scheme should something go wrong. You may also find that financial advisers are reluctant to recommend crowdfunding bonds, as they are liable for the due diligence and suitability of the diverse range of crowdfunding investments.
“So you will probably have to do your own research in an already opaque area,” said Thomson. “Accordingly this type of investment could be suitable for a wealthy investor for a relatively small amount of their portfolio. But given the limited impact it will have it is probably not worth all of the hassle.”