Beware of risks in bonds boom

SAVERS ploughed more than £200 million into Tesco Bank’s recent corporate bond issue in just two weeks as the search for income intensified. The popularity of the 5 per cent bonds forced Tesco to withdraw the product two days ahead of the scheduled closing date.

It wasn’t the first corporate bond issue to attract huge demand, and with low interest rates set to frustrate cash savers for some time yet, it won’t be the last.

But while savers are seeking an alternative to cash accounts, experts warn against underestimating the risks attached to investing in single corporate bonds. Here we look at some of the issues thrown up by the success of retail corporate bonds.

So what’s the fuss about?

The bonds have hit the headlines in recent weeks after a surge of demand for Tesco Bank’s 5 per cent corporate bonds. It was the third corporate bond from the supermarket giant, the previous two issues raising around £180m in total. Lloyds Banking Group, National Grid and John Lewis are among the other big names to have raised money by selling corporate bonds to private investors.

Minimum investment in the Tesco bonds was £2,000 and they pay 5 per cent in twice-yearly instalments until maturity in 2020. Following the issue, they will be available on the stock exchange, where they are expected to trade at a premium.

• Corporate bonds: The risks involved

What exactly are they?

Corporate bonds – not to be confused with fixed rate bonds – are effectively an IOU issued by companies to raise money. In return for buying the bonds, investors are paid a fixed rate of interest for a set period and are promised their capital back at maturity (unless they decide to trade them).

Individual company corporate bonds were out of bounds to ordinary investors until the London Stock Exchange launched a bond exchange in 2010. They can now be bought from stockbrokers for as little as £100, although most bonds need a minimum investment of at least £1,000.

Once a bond has been issued, it can be traded on the bond exchange, so investors can buy them second-hand from those who bought the initial issue. Investors have to put in at least £2,000 initially and can then buy the bonds in increments of £100.

The price at which the bond is traded will fluctuate according to the return it offers (5 per cent in the Tesco example) in relation to interest rates and inflation. They trade until they mature, so until 2020 in the case of the latest Tesco offer.

Why are they so popular suddenly?

The success of the Tesco issue attests to the great demand for income among savers and investors. In particular, they appeal to savers who have seen the income from their cash accounts dwindle since interest rates plunged to a record low of 0.5 per cent more than three years ago.

Recent corporate bond issues have promised investors a regular income of between 5 and 7.5 per cent, comfortably higher than that paid by cash accounts.

There’s also been a shift away from equities in response to market volatility, with continuing uncertainty in the eurozone boosting sales of so-called safe havens such as structured investment products, gold and fixed interest funds.

What are the risks?

Corporate bonds typically carry less risk than equities but more than shares, with the biggest threat being that the company issuing the bonds defaults on the repayments.

Many financial advisers are uncomfortable with private investors buying single corporate bonds. For example, it isn’t always clear at the outset how a bond will be priced when it is traded and what value it offers, as interest rate and inflation expectations and the creditworthiness of the issue can be hard to predict. If interest rates rise significantly over the next few years, for instance, the 5 per cent income paid by Tesco will be less attractive and the bonds will become harder to trade.

David Thomson, chief investment officer at VWM Wealth Management in Glasgow, said: “This can be a relatively complex area where an understanding of the covenants and backing provided to each bond is required.

“A further problem may be the illiquidity associated with some of these corporate bonds, and investors may find it more difficult to trade them than they anticipate, although this is also a problem for funds as well.”

Not all companies issuing bonds are as financially robust as the likes of Tesco and National Grid.

Also bear in mind that because the corporate bonds are investment bonds and not savings products, the £85,000 guarantee of deposits under the Financial Services Compensation Scheme does not apply in the event of the issuer going bust.

How do I know if it’s worth buying bonds?

Do your research, advised Adrian Lowcock at Bestinvest: “Firstly, you need to know a lot about the bond being issued. Just being issued by Tesco is not sufficient, as the bond itself may only be secured against a particular asset which may be riskier than Tesco as an investment.”

As Lowcock implies, the bonds issued by companies looking to raise money from investors tend to be secured against various types of assets, which affects the riskiness of the investments.

“Investors should take time to learn about the investment and ask themselves why the company is using the retail market to raise money,” he added.

How else can I get income from bonds?

A less risky way of accessing corporate bonds is through collective corporate bond funds or investment trusts which invest in a pool of corporate bonds.

Andrew Hannay, director at IFA Robson Macintosh, said: “This gives a much greater degree of diversification and a spread of risk. Sprinkle in some international investments, a little emerging-country debt, some global themes such as clean energy, water or infrastructure and you have a strong recipe for producing a consistent level of income that ought to be able to increase year on year.”

Thomson at VWM said: “For the average investor, it is much more prudent to invest in a managed fund to obtain access to both the investment management expertise and the diversification required.”