Wednesday, 18 December 2013

A Tale of Four Loan Markets (3) Mini Bonds

And New City High Yield Investment Trust

Routing paths through part of the internet, courtesy Wikipedia
The recent trend for individuals and businesses to seek financing from retail investors is the result of a convergence of events.
1.       The internet as a media for business transactions has grown in line with social activities, such as Facebook. As the public became accustomed to dealing with their bank or shop online, their trust in the internet grew and its convenience was demonstrated. Tapping retail savers for loans was a logical extension of the internet as a global market place.
2.       By eliminating the middleman, the internet consumer experienced savings too. Why not eliminate, or drastically reduce, the cost of the financial intermediary? Wouldn't this mean better savings rates for individuals?
3.       The rise of the internet as a market place coincided with the financial crisis. And the financial crisis destroyed the reputation of bankers. Individuals, as savers, are now predisposed to bypass the banks and the internet is there, beckoning.
4.       Quantitative easing and low Bank rates mean that retail investors can only obtain below inflation returns from their traditional sources, the banks, National Savings and Investments and the building societies. Internet-based savings sources offer better returns than traditional sources.
5.       After the financial crisis, banks reduced their loans to Small and Medium Enterprises (SMEs). SMEs were forced to look to other sources. And the retail saver was the least demanding and the cheapest source of funds.
6.       The British government, after the financial crisis, was desperate to get funds to SMEs. New financial products and internet-based intermediaries that offered a partial solution were welcomed with a light regulatory regime and, in some cases, with government funding.
Peer to Peer lending (since 2005), Peer to Business lending (since 2010) and the new ORB market for bonds (since 2010) were all created recently. (See previous articles at and
Peer to Business (P2B) loans are small - rarely over 100,000 pounds - and are designed for small businesses. The official bond market, which includes the ORB market run by the London Stock Exchange, is only available to large companies and the smallest issues run into the tens of millions of pounds. Banks used to be the only source of loans for enterprises that fall between P2B and the official bond market. Now Mini-bonds offer a source of loans for these same businesses.


Flash, C Comics, courtesy Wikipedia
The first mini-bond was launched by the toiletries concern King of Shaves in June 2009. The company aimed to raise 5 million pounds for a 3-year unsecured loan at 6% from retail investors. It actually raised 0.6 million pounds which was in effect rolled over with a second issue that raised 0.8 million pounds in 2012 from those same investors. The loan is not guaranteed by the Financial Service Compensation Scheme nor is it eligible for an ISA. Unlike P2B and ORB, the mini-bond is not transferrable or tradable. 
King of Shaves, a private company, did not provide a prospectus or any balance sheet or income statement. The latest accounts lodged with Companies House, as of 31 May 2012, show it has a negative net worth of 6.5 million pounds. From an investor's viewpoint, King of Shaves' mini-bond is at the extreme end of junk. Financing this sort of business is more suitable for venture capitalists, who will take a share of the equity, than for retail savers.
Given the lack of regulatory control, it is not surprising that the information provided by issuers of mini-bonds comes in many different forms. Ocean Capital PLC, for instance, is currently seeking 15 million pounds for an unsecured 3-year fixed term loan paying 6.5% p.a. 20% UK withholding tax is deducted from the quarterly interest payments. This offer closes 19 December.
Ocean provides the potential investor with a nine-page information bulletin that includes a current balance sheet, a pro-forma balance sheet for the parent company Ocean Capital Ltd. and a detailed explanation backed with numbers of how the funds will be used. Ocean is a finance house specialising in factoring (buying receivables from commercial concerns). Investors are informed that the net worth of the parent company is 528,000 pounds. After the fund raising, Ocean will have one pound of equity for every 55 pounds of assets. This loan would also be rated as junk by credit agencies.  
*See also Julian Hoffmann's article Mini Bonds under the Microscope published in the Investors Chronicle 29 November 2013.


Mini-bonds bear the highest risk of the four loan markets covered in this survey. Consider:
1. Risk of default. Any business can offer the public a mini-bond without any form of credit screening or security. P2P and P2B intermediaries use credit agencies to vet their borrowers. The ORB market requires a credit rating by one of the main agencies and/or a charge on assets, and as its main market are institutional investors, peer oversight is guaranteed.
2. Guarantees. The main P2P intermediaries are building up funds to compensate lenders for defaulting loans. P2B, listed bonds on ORB and mini-bonds have no such guarantees.
3. Regulatory oversight. Only the ORB market for bonds is presently covered by the Financial Conduct Authority. The other three all fall under the feeble oversight of the Office of Fair Trading.
4. Liquidity. ORB offers the most liquidity thanks to a liquid secondary market for bonds. P2P and P2B intermediaries offer lenders the possibility of selling on their loans to other parties. Mini-bond issuers do not. Investors are locked in for the loan period.
5. ISA eligibility. Only bonds quoted on ORB with a maturity of more than 5 years may be included in an ISA. All the other loans (P2P, P2B and mini-bonds) are subject to income tax at the individual's marginal tax rate.
Mini-bonds are a disaster in the making. Investors who are willing to take on more risk for a higher return, might consider investing in a high yield - junk bond - investment trust or exchange traded fund (ETF). These funds diversify their holdings, they can be bought and sold on the London stock market and they are eligible for inclusion in an ISA.

New City High Yield Investment Trust

New City High Yield Investment Trust (New City) offers a running yield of 6.4% at its current price of 64p. As the investment trust is registered in Jersey, it pays the interest gross of tax, and it is eligible for an ISA. The shares are priced at a 4% premium to net asset value.
New City invests 84% of its capital in fixed interest and 16% in convertible bonds and equity. The largest single holding accounts for 3.3% of New City's assets, and the company has a market capitalisation of 154 million pounds. 63% of its assets are denominated in sterling, with most of the remainder in US dollars. Administration, dealing and fee expenses (TER) amount to 1.2% of net assets.
Investor returns (based on the share price** in blue, net assets in red) for the past five years exceed the FTSE 350 High Yield Index (in olive) that this investment trust uses as a benchmark.
**Includes reinvested income.

Graph courtesy Investors Chronicle, click to enlarge
One attraction of New City is that it has increased its dividend every year since it was launched in 2007, averaging an increase of 2.8%. Another is that its net income has exceeded its dividend payouts, so that it has built up a revenue reserve worth over 12 million pounds that it could distribute. And one of the directors owns 2.2% of New City's issued capital, worth 3.5 million pounds.
For investors who prefer a passive fund, the ishares Global High Income Corporate Bond Hedged ETF (GHYS) offers a running yield of 6.8%. Expenses (TER) are 0.55%. The fund is sterling based and hedges for the US dollar, the Euro and the Canadian dollar. As it was only launched in June, historical data is too short to be of any interest.
While New City and GHYS offer investors a less risky alternative to mini-bonds, P2P or P2B, an investor will want to consider:
1. The yield spread of junk bonds over gilts is back down to the pre-crisis level of 2007. Increasing gilt yields would almost certainly be accompanied by a fall in the price of New City's and GHYS's junk bonds. Past returns are flattered by the abnormally low default rate on junk debt.
2. The recent low default rate on junk bonds has surprised financial commentators. It may be due to the low interest rates that weak companies pay for their loans. If so, and if interest rates were to increase sharply, then the default rate might rise. 
3. New City borrows about 8% of its gross funds and it may borrow up to 10%. While this leverage improves returns when they are positive, it further depresses returns when they are loss making. GHYS does not leverage its investments.

Friday, 13 December 2013

A Tale of Four Loan Markets (2): Peer to Business Lending

And the ORB Market

William Shakespeare, an investor, courtesy Wikipedia

Several years before his death, Shakespeare retired to Stratford upon Avon. He had accumulated a large patrimony of "barns, stables, orchards, gardens, lands, tenements and hereditaments", according to his Will, that he leased for rent. These income-producing assets were not without risk of default, but he knew the leaseholders and owned the properties. Most were not far from his home in Stratford.
Shakespeare took a time-honoured route to accumulating capital. In a matter of only a few years, individual savers have been offered routes that bypass the traditional institutions - the banks and official markets. P2P, P2B and the so-called 'mini-bonds'.
Peer to Business (P2B) Lending
Funding Circle launched P2B in the UK in 2010, since when it has matched loans of 188 million pounds. The procedure for lending funds is similar to Zopa's P2P (see
However, unlike the main providers of P2P, Funding Circle does not have any fund to protect lenders from default. Instead, the intermediary recommends spreading your loan over many borrowers. It provides a table of expected returns.
Credit rating
Net interest before
Default %
Estimated Annual Default Rate
Annual fee
Estimated Annual
Return %
According to Funding Circle, the average return for the saver is 5.7%. The interest rate that the borrower pays is between 1 and 2% above the rates quoted in the left-hand column of the table, with the difference going to the intermediary.
Typical borrowers are:
·         Accountants requiring funds for expansion. 30,000 pounds for 4 years, with an 'A' credit rating paying an average interest rate of 7.9% p.a. to Funding Circle.
·         Ecommerce expansion with a 'B' credit rating, 100,000 pounds for 3 years, paying an average interest rate of 10.6%
·         100,000 pounds for 5 years for a Sushi restaurant with a 'C' credit rating, paying an average interest rate of 10.6%.

In all three cases, the directors guarantee the loan, but there is no lien on any assets held by the business. The credit ratings come from Experian and Equifax, who are private enterprises that sell credit checks for profit.
Unlike Shakespeare, lenders to Funding Circle do not own any assets. The capital value of the loan is as much at risk as the income it provides. Funding Circle's estimate of the risk of default is based on a very short period of operation, and the credit ratings must be taken with a pinch of salt.
However, the government is so enamoured with alternative ways of funding small and medium enterprises (SMEs), that it is financially supporting P2B. Some of the loans are matched to 10% by the government. Unfortunately for the lender, this does not include any guarantee of the sums loaned.
Funding Circle, like the P2P intermediaries Zopa and RateSetter, is a small concern. It has a net worth of 6.5 million pounds and it has launched a similar business in the USA. In the event that Funding Circle fails, lenders are promised the support of Link Financial Outsourcing Ltd, a debt collection agency. Lenders are told that Link may not charge them more than 2% for its services, but it is impossible to know how much of the loans made through Funding Circle would be collected. And Link itself is a small company with a net worth of 5.2 million pounds.
Order Book for Retail Bonds (ORB)
The London Stock Exchange launched a new market to sell UK government (Gilts), supranational, local government and corporate bonds to retail investors in February 2010. Although retail investors have always had access to Gilts, Eurobonds and Convertibles, ORB offers an easier and cheaper way of buying bonds and in smaller quantities - as low as 1,000 pounds initially and 100 pounds thereafter. Individuals can now buy these securities online at their usual broker. ORB has also encouraged smaller and less credit worthy businesses to sell bonds to the public.
ORB had a retail turnover of 11.2 billion pounds in the month of November 2013. The largest single bond was National Grid's 'linker'. It offers 1.25% over the annual increase in the Retail Price Index and it matures 6 October 2021. Coupons are paid half-yearly and the bond is currently priced at 109p.
A variety of bonds is on offer. These include fixed rate (or conventional) bonds, floating rate notes, index linked bonds ('linkers'), zero coupon bonds and convertible bonds. And ORB has a liquid secondary market.
The Financial Conduct Authority oversees ORB and, as a result, the information available to the public is complete.
Places for People is but one of many UK property companies to tap the ORB market. Its prospectus for the bond it issued in June 2011 runs to 92 pages. Moody's gives the bond an Aa3 rating and, at the current price of 106.2, it yields 2.8% to maturity in 3 years time. This is a conventional bond with a coupon fixed at 5% and its maturity date fixed for 27 December 2016.
For investors wishing to use the tax shelter of an ISA or SIPP, any ORB bond with a maturity exceeding 5 years is eligible for inclusion. This is a clear advantage over P2P and P2B loans, which are not eligible for an ISA or SIPP.
One such eligible bond was recently issued by Bruntwood Investments, a large, private property company.  Its 6% 24 July 2020 bond yields 5.0% to redemption at its current price of 105.7. Although the bond is not rated by any credit agency, it has a charge on Bruntwood's properties. Pieces as small as 100 pound face value (106 pounds) may be bought on the secondary market. Bruntwood may redeem the bond early by paying the higher of par (i.e. 100) or the equivalent price of a 4.75% Gilt maturing in 2020 +0.5%. This would currently be much higher than the price of the bonds. Were Gilt prices to fall, then Bruntwood could redeem the bonds at a lower price. But in this scenario, Bruntwood's bond would also have declined in value on the secondary market.
The ORB bond market offers the individual investor the opportunity of creating a portfolio of bonds that fit his or her requirements. In the secondary market, individuals can invest as little as 100 pounds. Funding Circle's P2B offers better rates to the saver than a bank and, very often, than a bond traded on ORB.
Interest rates for lenders/savers
Best bank
3 years
2 to 4%
5 years
3 to 6%
However, Bank interest and ORB bonds (with 5 years duration) are tax-free for ISA and SIPP holders, who may not use P2B. Consequently, for 40% rate taxpayers the alternatives to P2B usually offer better after tax returns.
And P2B is a much more risky proposition than ORB:
1. P2B loans are for small businesses that might, and do, disappear. ORB bonds are issued by the UK government or large, well-known enterprises whose audited accounts are publicly available. The Gilt and Corporate bond market has a long history.
2.  The vetting procedure for P2B is quick & easy and superficial. ORB issuers must prepare a prospectus and the vetting procedure is based on a long experience of bond defaults.
3.  P2B loans are backed only by the directors. ORB issuers come with credit ratings by the big agencies and/or are backed by valuable assets
4. The companies that organise the P2B market are small and lightly regulated by the Office of Fair Trading. A failure by an intermediary will almost certainly lead to lenders losing money. Meanwhile ORB is part of the London Stock Exchange and it is regulated by the Financial Conduct Authority. However, this does not eliminate the risk of a default on ORB.
5. The notional returns on P2B may be overstated, as this is a new market with little experience of loan defaults. On the other hand, for very small sums P2B offers lower transaction costs.
6. The secondary market for ORB is very liquid. In the case of P2B, if the borrower is behind on his payments, the lender cannot sell on the loan.