12th Oct

Understanding the Risks as the UK Retail Bond Market Develops

The rapidly developing UK retail corporate bond market is attracting a more diverse range of issuers and this has raised concerns that some investors may not fully understand the potential losses they could be exposed to.

Since its launch in February 2010, the London Stock Exchange's electronic Order book for Retail Bonds (ORB), more than £2bn of retail bonds have been issued, and it is believed that annual volumes could rise to £3bn.

With annual returns of up to 6%, these securities are currently attractive to retail investors who would otherwise struggle to achieve 2% from bank deposits or government bonds.

Barclays, Lloyds and Evolution Securities (now Canaccord and Investec) generated early momentum in the sector by handling issues for Tesco Bank and Provident Financial, and later on by utilities such as Severn Trent and National Grid; this has generated interest from other banks such as RBS which is looking to join the party.

However recent issues from property-based businesses such as St. Modwen and Workspace Group, have ignited discussions about whether investors fully understand the risks they are exposed to and how they would fare in the event of a bankruptcy.

David Cleary at Lloyds is attuned to the issue, "The retail bond market is coming of age, and there is a lot of interest from UK plc, but there is definitely a divergence forming and we are seeing the beginnings of a two-tier market,"

In the past, deals have had a simpler financing structure with lenders and bond holders holding equal risk. The recent property transactions, however, grant lending banks security over a large proportion of assets and upon default, after equity stake holders, bondholders absorb the first losses, leaving bank lenders with greater protection.

A challenge for issuers and distributors is to ensure that the inherent risk in a product is appropriate to its target market. Investors must be comfortable that the risk they are exposed to is appropriate to their own objectives and attitude to risk and all potential pitfalls must be clearly explained in the prospectus.

However, the popularity of recent bond issues suggests an increasing appetite from retail investors and the challenge for the industry is to ensure that increased competition for funding does not lead to ever-riskier and complex product structures.

Risk and Return

More than £1.3bn has been raised on ORB in 2012, and every indication is that the UK market for retail bonds will mirror the success of those in Italy and Germany.

With distributors incentivised to sell bonds, it is imperative that due regard is paid to the credit quality of the issuer. This is particularly important where the distributor is an advisory firm, and therefore potentially less familiar with the treatment of bond holders in the event of insolvency.

The differential in pricing on recent bond issues, certainly suggests that investors have been able to distinguish riskier deals with the LSE itself raising £300m at 4.75% over nine years whereas St. Mowden had to offer 6.25% over seven years to achieve its target of £80m. The fact that the LSE opted for the retail market is an endorsement of its commitment to ORB and the terms of its issue pay testament to the recognition of the LSE brand as well as its financial probity.

The key to the future development of the retail bond sector will be ensuring that access is provided to the many smaller players who wish to access this form of finance. For banks to feel comfortable in supporting this business it is important that bond holders are seen to be given an equal footing to lenders and the trend towards more complex deal structures may hinder this process.

Even a full prospectus outlining all potential risks associated with bonds may not prove sufficient to allay the fears of banks so recently battered by mis-selling scandals, and it is inevitable that there will be a push towards greater transparency and an ‘apples-and-apples’ method of comparing the retail bonds products that are on offer.

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