Corporate bonds: High return, potential pitfalls

The Jockey Club's 'mini-bond' is aimed at raising �15m for a new grandstand at Cheltenham. Picture: Getty
The Jockey Club's 'mini-bond' is aimed at raising �15m for a new grandstand at Cheltenham. Picture: Getty
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SAVERS desperate for inflation-beating ­income are piling into eyecatching new bond offers unaware of the risks they’re taking, ­experts have warned.

With interest rates at record lows the opportunity to secure regular income of 6 per cent or more was bound to be tempting. And so it’s proved as a new batch of so-called retail bonds paying more than double the best cash Isa returns pull in millions of pounds from savers.

However, their popularity has sparked fresh fears that bond issues are being snapped up without the buyer understanding what they’re getting into. And while the income is attractive, advisers say there are pitfalls to be aware of ­before diving in.

So what are retail bonds, and why are they attracting so much money from ordinary savers and investors?

The term refers to corporate bonds that are issued by companies to raise funds. Investors buying the bonds are promised a fixed rate of income for a set period and their capital ­returned at maturity.

Some £3 billion has flowed into around 30 retail bonds issued over the past two years, it’s estimated.

A year ago Tesco was inundated with demand when it launched a bond paying 5 per cent twice a year until they matured in 2020, with a minimum investment of £2,000. Around £200 million was ploughed into the bonds, forcing the supermarket giant to withdraw the offer ahead of schedule.

This month has seen another flurry of interest. The Jockey Club last week reported strong demand for its 7.75 per cent “mini-bond”, which is aimed at raising £15m to pay for a new grandstand at Cheltenham Racecourse. The target has already been met but the offer remains open until later this week to investments of £2,000 or more.

Meanwhile, Nuffield Health’s 6 per cent bond is available at minimum investments from £1,000. The bond, which also seeks to raise £15m, has a five-year term.

Contrast that with the interest rates available from cash savings products, where the best four-year fixed rate bond pays just 3 per cent. The average five-year fixed rate bond has plunged from 3.99 to 2.42 per cent in a year, while Isa ­returns have plunged since the launch of the funding for lending scheme last summer, forcing savers to seek income-producing alternatives.

That need is sending many into choppier waters, however, as corporate bonds expose savers to far greater risks than cash-based products.

One is the possibility of the issuer defaulting on the repayments. While it may seem unlikely that the likes of Nuffield, the Jockey Club and Tesco would find themselves in this predicament, recent years have underlined the folly of taking financial stability for granted.

“Issuer default would leave bondholders as (most usually) unsecured creditors, ranking behind many others,” said Paul Lothian, director at Verus ­Financial Planning in Dundee. “Investors might only receive back a portion of their capital and may possibly lose their ­entire subscription.”

Damage to the issuer’s reputation can hit bondholders too, even if the company’s woes stop short of defaulting.

“If market confidence in the creditworthiness of the issuer falls, the yield on the bond would increase dramatically, which is to say that the bond’s capital value would fall,” said Lothian.

Many corporate bonds fell in value by 40 per cent or more during the credit crisis as ­confidence dwindled in the ability of companies to meet their obligations.

Then there are the smaller details that could cost investors dear. Look under the ­bonnet of the offer from the Jockey Club Racecourse Bond Company, for example, and it quickly becomes clear that it’s not a straight 7.75 per cent ­income deal.

Instead, bondholders get 4.75 per cent a year in cash and the remainder in the form of “racing points” that can be used at the club’s 15 racecourses across the UK.

The 4.75 per cent doesn’t compensate for the risks taken, according to Adrian Lowcock, senior investment manager at Hargreaves Lansdown

“Investors are being paid to invest in one company in an unlisted bond, which is not covered by the Financial ­Services Compensation Scheme (FSCS) and is an ­unsecured loan against the company,” said Lowcock. ­“Personally I wouldn’t bet a pony on this one.”

Retail corporate bonds aren’t savings products, which means they don’t come with the £85,000 deposits guarantee provided by the FSCS in the event of the issuer going to the wall.

Advisers also point to the length of the contracts. The Tesco issue last year doesn’t mature until 2020, while the Nuffield and Jockey Club bonds each have five-year terms. So while yields of 6 per cent and above are eyecatching in the current climate, any increase in interest rates over the next five years will not only dull their appeal, but make the bonds harder to ­offload.

Liquidity is particularly worth keeping in mind on the Nuffield bond, as it’s not traded on the stock exchange. Instead it acts like a fixed rate bond when it comes to access – with no early redemptions allowed the capital is tied up with Nuffield for five years.

The bonds are an attractive proposition, however, hence the demand for those issued by high-profile brands in ­particular. But advisers urge investors to look at other ­options before committing. Corporate bonds can also be accessed through unit trusts and investment trusts, which spread the risk by holding a basket of them.

Several corporate bond funds offer yields of more than 5 per cent, even though the bond rally of recent years has run out of steam. And while they can be risky, bond funds offer more diversification than single-issues and are available in tax ­wrappers such as Isas and self-invested personal pensions. “The best way to buy exposure to corporate bonds is through a fund,” said Lothian. “These are widely diversified across dozens of ­individual issuers and bonds, and are protected by FSCS in the event of the insolvency of the fund manager.”