Retail bonds: The pros and cons

Ten years ago, bonds were one of two sorts: gilts from the UK government or corporate bonds. Fast-forward to 2013, and investors are now faced with a dazzling array of bond investments; including retail bonds, which are now a hot topic.

In the past few months, retail bonds from property company Helical Bar, Australian renewable energy firm CBD Energy and gym group Nuffield Health have sprung up on the market. And the demand is evident: racecourse owner The Jockey Club, which issued a retail bond paying total gross interest of 7.75% a year to investors, recently announced it had raised almost £25 million - far exceeding its initial target of £15 million.

The market for retail bonds - income vehicles launched by a company specifically for the retail market - started to properly kick off back in February 2011, when the London Stock Exchange (LSE) launched its Order Book for Retail Bonds (ORB). Companies found it a cheap form of finance at a time when interest rates were at all-time lows.

At first, only large FTSE 100 (UKX) companies launched bonds on the platform. Tesco, National Grid and GlaxoSmithKline were some of the inaugural retail bonds and paid competitive rates of interest.

As the base rate has been hanging at 0.5% since March 2008 and cash savings rates aren't much higher, should investors turn to retail bonds for that all-important income?

Warnings for retail bond investors

• They are not the same as cash, despite their interest rates constantly being compared. They are tranches of debt issued by a company, plus interest, that will be repaid at a later date. So if their value falls (or the issuer goes bust) investors are not covered by the Financial Services Compensation Scheme.
• Retail bonds can be unreliable. Haulage company Stobart announced it was to launch a retail bond last November, paying a coupon of 5.5%, but pulled it later that month after larger bond issuers entered the market paying a higher interest rate.
• Understand what the bond is backed by and how it earns its income. For example, the retail bond from property company Places For People is backed by rent payments, but the income stream from travel website Mr&Mrs Smith is less transparent.

In the past few years, there have been issues from a wide variety of companies, including Tesco's financial arm Tesco Bank, property company Places For People and brokerage Tullett Prebon. The main benefit of retail bonds is their superlative interest rates - nudging high single-digits - and is why investors are buying into them in droves. Compare that to a cash savings account - the top fixed-rate cash account is ICICI Bank's 2.55% over three years, according to moneywise.co.uk/compare.

Listed and unlisted bonds

It's important to distinguish between listed and unlisted retail bonds, the latter of which are becoming increasingly popular. The difference between them is key. Listed retail bonds can be bought and sold through the LSE's ORB, which provides liquidity to investors and allows the bonds to be sold on the secondary market. Also, most bonds listed on the ORB can be included in an ISA or SIPP wrapper for tax benefits.

Then there are the unlisted bonds. Many of the recent launches are of this type, or 'mini-bonds' - a phrase coined by business group Capita - such as those from Nuffield Health and The Jockey Club. These type of bonds are not listed on any market and therefore must be held to maturity. Typically, they are issued from smaller, more unfamiliar companies and are generally not suitable for first-time investors.

Another pitfall with unlisted retail bonds is that most are not ISA-able. As an example, the interest rate for the Nuffield Health bond (paying 6% gross) automatically gets cut to 4.8% for basic-rate taxpayers, and 3.6% for higher-rate taxpayers.

Recent research from Capita shows that the mini-bond market is set to boom: it expects the sector to grow to £1 billion this year and £8 billion in the next five years as investors pour their money into them.

Adrian Lowcock, senior investment manager at Hargreaves Lansdown, is a keen commentator on the risks of the mini-bond market. "Unlisted investments are inappropriate for the majority of retail investors. Investors are taking risks when lending money to a company, and I urge investors to think carefully about the suitability of mini-bonds before they buy," he says.

Patrick Connolly, certified financial planner at Chase de Vere, warns against assuming the health of a company's balance sheet. "We have seen how even supposedly strong and secure companies, such as the high street banks, can get into financial difficulties and so you must understand the risks of relying on just one company to pay you," he said.

There's also the matter of missing out on capital gains. "It is very easy to get sucked in by the headline yield and forget about the risk to capital," says Jason Witcombe, chartered financial planner at Evolve Financial Planning.

"With a bond, if the issuer stays solvent and investors hold their investment to maturity, the original capital will be returned. But if investors want to sell their investment at any point in between, they may find that the price someone will pay for this is much lower than the original investment."

Paid by perks

Lastly, investors shouldn't be swayed by a perk. The Jockey Club bond, for example, pays some of its gross interest rate in the form of loyalty vouchers. Some of the more bespoke bonds offer more unusual perks - Hotel Chocolat, for example, even pays its monthly coupon in chocolate. While a nice perk, investors must weigh up these benefits with the potential cash value.

Also, the higher the interest rate, the higher the risk that the company might default - and as retail bonds are issued from one company only, it can be a risky strategy for a novice investor.

Most advisers claim a safer way for a first-time investor to buy bonds is through a bond fund. Connolly recommends Fidelity Moneybuilder Income or Henderson Strategic Bond. "Both invest in a large number of underlying bonds," he says.

A bond fund also offers capital growth on top of a monthly income. For example, Jupiter Strategic Bond returned 7.6% in capital growth over the past 12 months, according to Lowcock, alongside a gross income of 5.4%.

It seems the old adage still rings true: don't put all your eggs in one basket - and don't be swayed by a good interest rate.