Are Mini Bonds the ideal solution in a low-interest rate world?

With savings rates dismally low, investors are searching for better rates of return. Mini bonds, which are loans to companies, certainly offer investors a great deal more but are they worth the risk?

As far as companies (usually small to medium size) are concerned, mini bonds offer an ideal alternative to bank finance.

To circumvent the bank, the company goes direct to individual investors and in return for their money, the mini-bond provides income via an agreed ‘coupon’, paid at regular intervals (quarterly, half-yearly or annually).

At the end of the agreed term the investors capital is returned in full. In theory, the company has benefited from a cash boost to develop its business.

Everyone’s a winner

It has been able to raise finance at competitive rates at a time when some banks are still reluctant to lend to many firms.  From the investor’s perspective, they receive tidy interest on their capital for their trouble.

The rates of interest on offer from mini-bonds certainly are attractive typically ranging between 6% to 8% (compared to many bank or building society accounts paying around 2%).   

In recent years, companies as diverse as Hotel Chocolat, John Lewis, Ladbrokes and the University of Cambridge have issued mini-bonds as a way of securing debt-based finance.

 Mini bonds have also been used as a source of finance in the world of rugby. Harlequins launched a five-year, 5.5% mini bond in order to raise £7.5million for club development. Their arch rivals Wasps also launched a bond offering 6.5% and the club hit its £35m fundraising target within days.

Wasps rugby launched a mini-bond to fund club development

Mini-bonds benefit from the loyalty of their investors who frequently have an emotional attachment to the issuer in question. It allows investors to feel more involved and play an important role in the future success of a brand they have an affinity with.  

So, it’s’ a win-win situation? Well not quite.  As Patrick Connolly, Certified Financial Planner with Chase de Vere, points out, while returns on mini bonds can appear very attractive, particularly with general interest rates at historic lows, it would be a mistake to compare their rates directly with those from savings accounts.

 “The danger is that investors don’t fully appreciate the risks they’re taking and that they are putting their money at risk, especially if the bonds are offered by companies which they know and trust.”

No safety-net

He adds: “Unlike with most UK based savings accounts or investment funds, investors in these bonds cannot fall back on the Financial Services Compensation Scheme (FSCS) if it all goes horribly wrong and their provider is unable to pay them interest or repay their capital.”

And this does happen. In January 2015, we saw a high-profile default when the mini bonds issued by Secured Energy Bonds plc stopped paying interest to investors.

Buyers were assured at launch that the money would be used to install solar panels on schools across the UK. But they were installed at only six of the 22 schools planned. The money raised from investors went, instead, to prop up the parent company, CBD Energy in Australia which had financial troubles.

There is clearly a danger in relying on just one company or organisation to pay you back. As Justin Modray, IFA at Candid Money points out, these bonds are effectively loans, so you need to be confident the company borrowing the money can afford to repay you at maturity with interest along the way. 

“The cost of making a mistake could be high, since any losses will not be covered by a compensation scheme.”

 He adds: “Unfortunately judging company’s current and future financial health is the single biggest obstacle for most of us. Dissecting accounts and understanding the company’s market is a difficult for professionals, so nigh on impossible for most private investors. And you also have to question why the company is targeting private investors, did it struggle to raise money from professional investors?”

Connolly takes a similar line. “Investing in a single company, whether that is buying shares or mini-bonds, is a high-risk approach, especially if the money represents a significant proportion of your overall investments.

“We have seen how even supposedly strong and secure companies, such as the high street banks, can get into financial difficulties.”

Access issues

In addition to company risk and lack of compensation there are also potential liquidity issues as most mini bonds aren’t actively traded. This means investors will struggle to access their money until the bond matures. That may be totally acceptable to the investor but it does represent a degree of inflexibility.

Mini bonds are clearly not for everyone. Any investor considering putting some money into mini bonds should have a healthy appetite for investment risk and, most importantly, the capacity for losses.

Indeed, Aldwyn Boscawen, marketing manager at UK-based mini bond provider Wellesley agrees that they will never be, nor are they designed to be, a mass market product. “Mini bonds should not be seen as an ‘alternative to cash’ they are very different in terms of the risk involved – they are an investment not a savings product.”

With this in mind, Wellesley have introduced an online ‘suitability questionnaire’ which outlines the risks to potential investors taking into account their circumstances and net worth.

Caveat emptor

Modray appreciates the appeal and potential returns on offer from mini bonds but stresses the buyer beware maxim.

“I love the mini-bond concept and it can help support good companies while offering investors a decent return along the way. But sorting the wheat from the chaff can be extremely difficult and I do fear many investors are parting with their cash without really appreciating the potential risks involved.”

These sentiments are echoed by Connolly: “For most people, the extra risks involved in buying mini bonds, together with the lack of protection, mean that they aren’t suitable, and where they are used it should only be for a very small proportion of an overall portfolio.”