22 May My word is my (mini) bond
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With depressing regularity, investors in assets which they were told were secure turn out to be anything but that. I draw the distinction here between those whose falls are simply a function of broad market movements which affect all publicly quoted assets and those where the underlying assets were simply not able to deliver what was claimed of them.
The latest operation to fail is the Blackmore Bond, a ‘mini bond’ into which investors sunk around £45m in the expectation of achieving annualised returns of 9.9% over five years. In an interest rate environment in which 1% is a respectable return for a low risk investment (it is what the UK government-backed National Savings & Investments will pay on a deposit), it is perhaps unsurprising that people are attracted by the prospect of higher returns. This is particularly if the risk is described as low.
In 2016, when the investment was launched, investors were invited to invest a minimum of £5,000 each into a portfolio of property development projects. The mechanism involved investors lending to the company by purchasing bonds from it. The funds raised would then finance a development project and when complete and the properties were sold to homebuyers, the proceeds would fund the repayment of the bonds to the investors. In the meantime, they would receive quarterly interest payments for the use of their capital.
Blackmore first raised concerns when it missed its October 2019 payment and then it missed the January 2020 one as well. As we know, the UK housing market was then effectively frozen when the Covid lockdown took place. In the meantime, most building sites have been closed due to the impracticality of workers on them maintaining the recommended two-metre separation from their colleagues. The difficulties in obtaining finance, personnel or supplies to keep their sites functioning have affected many property companies but for most of those not involved in the sector, this has been of peripheral interest.
The warning signs are, as usual, fairly consistent:
Mini bonds such as these are not quoted or traded (the issue size is too small to be of interest to most potential buyers in the secondary market, regardless of the merits of the particular issue). This presents investors with two problems.
One is that with no effective public market for the bonds, there is no mechanism for the price to be determined by market participants. Quoted bonds, such as those issued by governments and large companies, are subject to continual pricing that reflects supply and demand in the market. If the bond looks attractive, then its price will rise and if not, it will fall, to a level at which investors believe its future returns fairly reflect its risks. Price and the future return of a bond are inversely related (because the maturity price is fixed), so a rising price caused the future return to fall and vice versa.
The second is that if the issuer defaults (such as by missing an interest payment, as happened in October last year), the investor has no realistic mechanism for voting with their feet and selling to someone else. Obviously with a quoted bond which missed a payment, the price would be affected but at least the investor could make a choice as to whether to accept that price or hold in anticipation of things improving. When there is no potential buyer to set that price, there is no prospect of exit.
Not all bonds are low risk
Although bonds, when taken as an entire asset class, are generally less risky than owning the shares of a business (equity) since their holders are only lending to the business rather than owning it, the picture is rather more complex in reality. Capitalism works as a mechanism for allocating capital efficiently by allowing investors to compare the expected risk of an enterprise with its expected return.
Consider two entrepreneurs pitching to you for a loan to their businesses. One has a history of successful businesses behind them and is now looking for investment to help her start a new business in a sector which she knows well. She has a business plan, premises, key staff hired and knows who her target market is and what the likely demand is for the new businesses offering. The other is an idea dreamed up by my son and one of his school friends while watching videos during lockdown. They have no experience, no business plan and, if I am honest, no clue.
In both cases the proposal is that you lend to the business rather than owning part of it but the principle is the same and even though one of the candidates is my son, I know which sounds the more likely to give me my money back when agreed. If other potential investors agree, this risk will be reflected in it costing him more to raise capital. With equity, he will need to forego more of the business, while with a loan, it means a higher interest rate. The return that an investor receives from any investment is therefore effectively the cost of capital incurred by the investee.
The nature of the underlying business is everything when considering investing in it and this is the case whether you are a bond or an equity investor. With some businesses, the chances of losing everything you put in may not be materially different regardless of which of the two routes you select. If you are lending to a business, it helps to think like a bank, which does this all the time. The business’s profits are what will provide your returns, so if there aren’t any left after costs, that affects you.
Some assets are easier to sell than others. Let me qualify that – some assets are easier to sell at a price acceptable to you than others. I suspect that if you were having difficulty selling your house (at least when the country were not in lockdown), offering it for £1 would probably change that. However, if you had an outstanding mortgage of £200,000 on your house, that might affect the sort of price for which you were willing to sell it. While this has no impact on what someone might be willing to pay (your mortgage is your problem), it probably is a factor in what you are willing to accept.
Nevertheless, as anyone who has done it will know, selling property can be a lengthy and expensive process. There are far more potential obstacles than when trying to sell quoted shares, for example. Delays of weeks or months are not uncommon and even then transactions can collapse because of the circumstances of another party over which you have no control or influence. While a countrywide lockdown might not have been regarded by anyone as a likely scenario, any number of other situations could have arisen to present challenges to the speedy liquidation of properties at a price that would satisfy the vendor.
Who is ahead of you in the queue?
Notwithstanding the illiquidity of property, it is consistently popular with lenders as a form of security. This means that if the company decides to raise finance elsewhere (for example, from a bank), that lender will likely demand a charge over some or all of the company’s assets to protect its own interests. Since secured lenders are ahead of bondholders in the queue if the business fails, this does no improve the chances of the bondholders getting their money back.
The form book
When assessing the risk of a borrower meeting its obligations to lenders, one of the standard criteria used by lenders is the track record. Has it previously been a good borrower and repaid its obligations in full and on time? Has it done so on multiple occasions over a substantial period? Those without such a track record will generally be considered riskier than those with a good one. Of course not all borrowers have such a track record but then a lender is not obliged to lend to those which do not meet its criteria. Neither, self-evidently, is a potential investor. Banks have procedures and trained analysts to assess these risks; private investors, particularly those who might be attracted by the prospect of apparently high returns at low risk and a low minimum investment, do not. Targeting investors who are unlikely to have the knowledge to scrutinise the potential opportunity adequately is an indicator that the opportunity may be less good than advertised.
Who else has their fingers in the pie?
All trading businesses have counterparties, other businesses with which they carry out transactions. Most of these will be normal and no cause for concern; for a property developer, they might include builders, material suppliers, banks and surveyors. However, it is worth considering the extent to which other counterparties might also be involved, particularly where their contribution is less clearly beneficial. In particular, are there unexplained payments to entities owned or controlled by the same people who control the business which you are being asked to finance? Are there management fees being paid and if so, to whom? Are there commissions or introductory fees being paid to other entities and which seem disproportionately large? Blackmore, it appears, paid 5% of the funds raised by the bond issues to a separate company controlled by its directors and a further 20% to a marketing agency, Surge Group. The latter, interestingly, is the same company which was promoting the LC&F bonds which collapsed last year.
In November 2019, the Financial Conduct Authority announced a 12-month ban on the promotion to most retail investors of ‘speculative illiquid securities’, which it describes 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.’. The ban is effective for the current year and follows criticism over last year’s London Capital & Finance collapse, which I covered in a previous blog. However, this does not amount to a ban on issuance, so you may still come across offers for mini bonds, even if they are not called that.
While the FCA has some powers to take action where it perceives investor detriment, we should always be alert to tempting opportunities which may be less than they seem. Although such opportunities may be legitimate (as appears to be the case with Blackmore – there is no evidence of fraudulent activity there), this does not mean that they are sound investments. If you come across something that seems too good to be true, pause and ask yourself why. If the answer is not obvious, ask a professional who probably sees this kind of thing frequently and is likely to be able to separate out the good from the less so in short order.