Concerns mount over UK retail bond issues

By most measures, the London Stock Exchange’s order book for retail bonds has been a runaway success.

Since its launch in 2010, the electronic hub has hosted 38 corporate bond issues and raised £3.4bn from yield-hungry small investors, who have been able to snap up the bulk of these issues in denominations of just £100. As yet, not one of these retail bonds has defaulted and most are trading above par.

The development filled an embarrassing hole in the UK’s capital market landscape; whereas countries such as Germany, France, Italy and Spain have long had flourishing retail bond markets, UK companies’ historic unwillingness to issue paper in denominations of less than £50,000 had long stymied a similar market in London.

“In terms of the development of the market, it has been a very good thing,” says Kate Ball-Dodd, a partner at law firm Mayer Brown, who has worked on several retail bond issues. “It has allowed access to a type of investment that was difficult for retail investors to access before because of the very high denominations.”

However, some investment industry professionals are raising concerns about the nature of some of these bond issues.

“There is a very good reason why companies go direct to the consumer and it’s because the companies’ benefit. They can sneak out a bond with lower protection [than in the institutional market] or they can get it away with a lower yield,” says Stephen Snowden, a bond fund manager at Kames Capital.

Tom Becket, chief investment officer at PSigma Investment Management, a wealth manager, adds: “I have absolutely no problem with high quality companies going to the nascent retail bond market, but all too often these are companies that are being opportunistic.”

One concern is that retail investors may be unwittingly assuming more risk than traditional institutional bond buyers.

National Grid and Severn Trent have issued retail bonds backed by cash flows from their holding companies, rather than the regulated operating companies that stand behind many of their bonds aimed at institutions.

The key difference is that the regulated entities are barred by the regulator from taking on too much debt, reducing the risk to lenders. In contrast, at the plc level, “there is no limit, within reason, on the amount of debt you can put into that entity,” says Mr Snowden.

“In the Enron scenario, people who had bonds issued by the holding company lost everything and those issued by the operating company were OK,” he says, referring to the collapse of the infamous US energy company in 2001.

These differences are recognised by the credit rating agencies, which typically assign a higher rating to debt that benefits from this “regulatory ringfence”.

“[A retail bond] might have a good name on the tin but the debt may be issued by an overseas subsidiary,” says Jason Hollands, managing director of Bestinvest, an investment adviser.

“There have been some high quality issues, but often people don’t realise [the issuer] is an offshore subsidiary. You need to know where you sit in the capital structure of the overall business if the company runs into trouble.”

Martha Walsh, a spokeswoman for Severn Trent, says that, under the UK’s prospectus directive, retail bonds can be issued only by entities that publish semi-annual accounts, in line with the rules for listed equities. “Severn Trent plc [the holding company] is the only group company to make up half-yearly accounts, so we had to select that as the issuer or publish accounts for Severn Trent Utilities Finance plc [the regulated entity].”

Gillian West, a spokeswoman for National Grid, says: “The retail bond we have issued is by the parent holding company, National Grid plc. We have many institutional targeted bonds. Some are issued by holding companies and some are issued by our regulated operating companies.”

Mr Becket also raises the example of Tesco Personal Finance, the banking subsidiary of the retailer, which has issued three retail bonds. He questions whether all the buyers have understood that the debt is issued by a subsidiary, not the parent company. “I would wager that many people have bought because it is Tesco,” he says. Tesco declined to comment.

Ms Ball-Dodd believes these subtleties are adequately flagged. Helical Bar, the most recent issue Mayer Brown worked on, had the first retail bond prospectus approved by the new Financial Conduct Authority, and “in line with the FCA’s focus on retail investors …both the format and the language were revised significantly so they were more digestible,” she says. Many prospectuses now include diagrams of the corporate structure.

However, Mr Snowden also cites examples where retail and institutional bonds have been issued by the same entity, but with the retail version paying a lower coupon. For instance, Provident Financial, a subprime lender, simultaneously issued a retail bond with a 7 per cent coupon and an institutional one paying 8 per cent last year.

Amid a broader UK political backlash against subprime lending, Mr Snowden also argues that prudent investors should limit their exposure to a company such as Provident Financial, something easier to achieve in a diversified bond fund than an ad hoc private portfolio.

Mr Becket says: “Our advice would always be to [invest in bond] funds. Yes, they can be more expensive at face value basis [because of the annual management fee], but they might be paying less for bonds than retail investors [and] it makes sense to spread your default risk.”