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June 12, 2011

Lending to firms can bring tasty returns, but there are risks for ordinary investors

Pioneering investors have turned the traditional idea of bank borrowing on its head.

Rather than borrowing from the banks, they hope to make solid returns by lending their own money to companies including Lloyds TSB and Tesco Bank.

These are among the growing number of businesses raising money by issuing corporate bonds aimed directly at ordinary investors. As Financial Mail reported in the Midas column last week, housing association

Places for People is the latest to announce a bond.

Directly investing in such corporate bonds is new territory for many investors. And while the returns can appear attractive, there are risks along the way.

Financial Mail explains how these investments work. bank borrowing on its head.


Why are companies fundraising in this way?

The process was kick-started by the introduction last year of a consumer friendly electronic dealing system for bonds on the London Stock Exchange called the Order book for Retail Bonds.

This has cut the minimum investment from £10,000 to £1,000 and has simplified pricing for bonds. Tesco raised £125 million in February with an eight-year bond paying 5.2 per cent a year, and was last week talking to brokers about a follow-on issue.

Lloyds Banking Group offered a five-and-a-half-year bond in March paying 5.5 per cent a year, raising £150 million. And John Lewis raised £50 million in April through a Partnership bond, though this was reserved for its customers and staff.

Ged Hawley, head of capital markets strategy at Lloyds Banking Group, says: 'There is a culture of retail bond investing in Europe, but up till now that has not been mirrored in Britain.'

How do corporate bonds work?

A bond is effectively a loan to a company. You hand over cash for a fixed period while the company issuing the bond agrees to pay a set rate of interest for the duration.

There is usually a minimum investment, typically £1,000 or £2,000 and this can be topped up in units of £100 after that.

A bond can be kept for the duration and you should get back the original sum. But if the bond has been issued through the Order book for Retail Bonds it can also be traded on the stock market.

This gives investors the chance to sell if they need access to capital or want to crystallise their gains, or alternatively if they want to

buy into existing issues of bonds. While the interest rate is fixed, the buying and selling price of a bond can vary with economic and market conditions. For example, the Tesco bond issued in February at 100p is trading at 104p.

What is the attraction of bonds?

For today's income-hungry investors, the appeal is a fixed rate of interest that can compare well with returns on bank or building society accounts.

If a bond has a lifespan of more than five years, it can be held within an equity Isa or selfinvested personal pension, meaning all income is paid free of tax.

Sue Bowen, 63, signed up to an innovative bond from retailer Hotel Chocolat last year. The company raised more than £4 million by selling the bond to members of its Chocolate Tasting Club, who don't get interest but instead receive a box of chocolate either monthly or every other month.

Sue is a sales manager for an operatic recording firm. She invested £2,000 in the bond, which runs for three years, with the option to continue thereafter.

She says: 'I was paying £17.95 every other month for the chocolate, so saving that money is the return on my investment. It's more than I was getting leaving the money mouldering in the bank.'

The deal works out as a 5.38 per cent return after tax.

Sue, who lives in Stockwell, south London, with her husband, Desmond, 62, a retired civil servant, says: 'The investment is a bit of fun, but some of the money is being used to invest in a new factory at the plantation in St Lucia, so it is doing good work.'

And what are the risks?

There are two key worries. First is the credit risk – the danger that the company issuing the bond hits financial troubles and struggles to make the regular interest payments or to repay all the capital when it falls due.

Unlike a bank account, there is no protection for investors through the Financial Services Compensation Scheme.

Patrick Connolly of AWD Chase de Vere, in Bath, Somerset, says: 'Just because it is a household name issuing the bond does not guarantee it is safe.'

He suggests that most investors would be better off buying into a corporate bond fund (see below).

The second danger relates to interest rates. Bond investors are locking into a fixed interest rate.

As and when rates rise this return may look less attractive.

Generally, the capital value of bonds falls if interest rates climb sharply. And if inflation remains high, then the value of the capital invested may be eroded.

How do I invest?

To invest in a new issue of bonds, such as the Places for People launch, you need to contact one of the sponsoring stockbrokers.

Watch the retail bond news pages of the Stock Exchange website for details of upcoming launches.

Once a bond is trading on the stock market, investors can buy or sell through most stockbrokers.

Self Trade, for example, charges £12.50 per trade for online transactions or £17.50 for a deal over the phone.

The Share Centre will deal in bonds only over the phone, charging one per cent commission with a minimum charge of £7.50.

For more information, visit londonstockexchange.com and look for retail bonds in the 'prices and markets' section.

Spreading the risk The best corporate bond funds

Investors who like the idea of an income from corporate bonds can hedge their bets by putting money into a specialist fund.

This will buy bonds and other fixed-interest securities from firms and institutions, such as governments, though management fees will take a slice out of returns.

Patrick Connolly of AWD Chase de Vere, says: 'A fund will diversify your holdings spreading the money over many companies and reducing risk.'

Funds can specialise in a particular type of bond, such as higher yielding and more risky corporate bonds.

Or you can take a 'strategic' approach, which lets the manager move from one type of bond to another to find better value.

But unlike the fixed income from holding a bond directly investors must accept some fluctuations in the payout from a fund as the holdings change.

Ben Willis at Whitechurch Securities suggests the Jupiter Strategic Bond fund as a good 'go anywhere fund', which can invest across the entire spectrum of fixed interest. The fund, managed by Ariel Bezalel, yields 4.3 per cent, net of charges.

Another highly rated fund is Invesco Perpetual Monthly Income Plus.

By Stephen Womack

Source: www.thisismoney.co.uk

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