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Mini-Bonds Illustrate the Perils of Yield Chasing

Ever since the financial crisis, central bank policy, low inflation and investor demand have driven down interest rates on pretty much any type of fixed interest investment, ranging from corporate and high-yield bonds to gilts and savings accounts. This has left many retirement investors in a quandary: How can their portfolios possibly generate the cash flow they need to meet expenses? Unfortunately, to many, the answer is to add risk by diving into investments offering attractive yields—mini-bonds. In industry-lingo, we call this yield chasing, and it frequently doesn’t end well.

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The Low-Yield Environment

These investors’ problem is simple enough to understand. 10-year gilt yields, a benchmark for UK interest rates, ended November 2016 at 1.39%, slightly above an all-time low 0.64% set in in August and hovering around levels not seen since the South Sea Bubble burst in 1720. (Exhibit 1)

Exhibit 1: A Very Long-Term Chart of 10-Year Gilt Yields

Source: Global Financial Data, Inc., as of 1/12/2016. Monthly 10-year gilt yields, July 1700 – November 2016.

The low level of benchmark yields is also dragging down time deposits, corporates and even high-yield bond rates, starving fixed interest investors of necessary yield. (Exhibit 2) This is even more true after factoring in inflation, which leaves 5- and 10-year yields bouncing around zero. (Exhibit 3)

Exhibit 2: Selected Interest Rates

Sources: Bank of England, FactSet, as of 1/12/2016. UK Time Deposit Rate (Outstanding), Five- and 10-Year Gilt Yield, Bank of America Merrill Lynch UK Corporate Bond Index Yield and Bank of America UK High-Yield Bond Yield, December 2000 – November 2016.

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Exhibit 3: Selected Inflation-Adjusted Interest Rates

Sources: Same as Exhibit 3. All are inflation-adjusted by subtracting the UK year-over-year CPI rate.

Enter Mini-Bonds

The result of this is the same all over the world: Investors are chasing risky products in search of yield, allured by high-seeming rates. In the UK, this has most recently metastasised in the form of mini-bonds. Mini-bonds are unregistered debt securities issued directly by small businesses to the public, who offer financing for various projects. This has become an increasingly popular form of business “crowdfunding” in recent years, as bank lending for such ventures has been tough to come by. As such, these issuers float privately placed debt at rates typically ranging from 6% - 8%.i Many yield-hungry investors dove in.

A key investing tenet we live by is this: If an investment offers yields four, five, six, or seven percentage points above government bonds—widely considered the asset with the least risk of default or bankruptcy—it is astronomically more risky. Mini-bonds are a case-in-point. The reason they offer such high yields is they have to. As the Financial Conduct Authority noted in a 2015 paper, “[Mini-bond issuers] may have found it difficult to secure a loan from a bank or could be start-up businesses looking for funding.”ii Such businesses may be alluring, but they are hugely risky. And, what’s more, because these securities are unregistered and don’t trade on exchanges, investors frequently can’t get out of them. If you realise a risk lurks, there is frequently very little you can do to hedge it.

Whilst the yield may be attractive, mini-bonds are a hugely risky way to generate income from your portfolio. And recent news is bearing this out. In 2015, so-called “Secured Energy Bonds” defaulted, leaving investors wondering what “secured” meant, in all likelihood. This year, 1,000 investors who owned mini-bonds issued by a company calling itself “Providence” were proven fraudulent.

Yet issuance remains brisk. Our humble suggestion: Don’t be blinded by the shiny rate and safe-sounding names. These instruments can be dangerous to your financial health.

Fisher Investments UK Retirement Guide for £250k+ Portfolios from Ken Fisher's Firm

i Source: “A Review of the Regulatory Regime for Crowdfunding and the Promotion of Non-Readily Realisable Securities by Other Media,” Financial Conduct Authority, February 2015.
ii Ibid. Page 9.

This article reflects the opinions, viewpoints and commentary of Fisher Investments MarketMinder editorial staff, which is subject to change at any time without notice. Market Information is provided for illustrative and informational purposes only. Nothing in this article constitutes investment advice or any recommendation to buy or sell any particular security or that a particular transaction or investment strategy is suitable for any specific person.