Mini-bonds are a relatively recent financial innovation which emerged shortly after the 2008 credit crunch. As small and medium sized companies struggled to raise the cash they needed from banks to grow and develop their businesses, alternative sources of funding were needed.
One potential source of finance for companies was to use their existing customers (consumers who were already familiar with the company, its products and its ethos) to provide the funding needed. This led to the emergence of a new type of financial product which is now referred to as a mini-bond.
They are called mini-bonds because the money was raised from several hundred, if not thousands of investors, in the form of small amounts of cash from each individual. In other words, a mini-bond is an unlisted debt security, typically issued by small businesses to raise funds.
A mini-bond is a debt-based, unlisted, fixed income security. The investor is lending money to a company for a fixed period of time at a fixed level of interest. Unlike a shareholder, a bondholder has no equitable (ownership) interest in the business.
For example, if you owned shares in a company, the investment return is paid in dividends. Whereas, with a mini-bond, the investment return is paid in the form of interest income (or even other rewards, such as free or discounted products).
The prospect of higher cash returns (or other forms of return) means that mini-bonds have been quite popular with retail investors since they were launched. However, new rules issued by the Financial Conduct Authority (FCA) in November 2019, which are explained below, mean there are restrictions in place on who can buy mini-bonds.
Risks associated with mini-bonds
Mini-bonds are quite an attractive investment product as they usually promise significantly higher returns than is currently offered by deposit accounts at high street banks. However, mini-bonds are NOT a savings product and higher returns are payable because of the greater risks associated with this product.
However, raising funds through the use of mini-bonds tend to be used by smaller, less established companies with a higher risk of failure. Quite often, these loans might be unsecured or the security offered may not be enough to cover the loan, in the event of a borrower default.
As a mini-bond investor, you are exposed to this lending risk and you could lose a significant percentage of the money you have invested. They are considered much riskier than retail or corporate bonds.
Mini-bonds are not transferable to other investors and cannot be traded on a regulated stock exchange (like listed shares in say the FTSE 100) or bought and sold in the same way that retail bonds are. Therefore, they are considered illiquid. In effect, this means that an investor is locked-in for the period of time specified in the bond and cannot access their cash until the bond reaches its maturity date.
Mini-bonds are not considered a regulated activity by the Financial Conduct Authority (FCA) and accordingly are not covered by Financial Services Compensation Scheme (FSCS). So, should the company default on its obligations (fail to repay the bond) the investor is very unlikely to receive any compensation.
It should be noted that the FCA has stated that “there is no legal definition of a ‘mini-bond’ but the term usually refers to illiquid debt securities marketed to retail investors”.
Investor safeguards introduced by the FCA
As mentioned earlier under risks, mini-bonds are not considered a regulated activity by the FCA and are not covered by Financial Services Compensation Scheme (FSCS). However, if the ‘product’ was bought on the advice of an independent financial adviser authorised by the FCA, then some recourse may be available to the investor.
Probably in response to failure of London Capital & Finance, and the scale of potential losses suffered by private investors, the FCA has introduced restrictions over who can buy mini-bonds. With effect from 1st January 2020, the FCA introduced a temporary ban on the promotion of “speculative mini-bonds” to retail consumers, unless they are considered to be either ‘sophisticated investors’ or ‘high net worth investors’. For more information on these investor types, please click here.
In June 2020, the FCA confirmed that it intended to permanently ban the mass-marketing of speculative, illiquid securities, including speculative mini-bonds, to retail investors.
The FCA has defined speculative mini-bonds as “unlisted bonds and preference shares where the issuer uses the funds raised to lend to a third party, invest in other companies, or purchase or develop property”.
Other types of bonds
To learn more about other types of bonds available, please click here.
