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Q&A: What is a mini-bond?

The collapse of investment firm London Capital & Finance has prompted a probe by the Financial Conduct Authority into how these products are regulated.

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The collapse of investment business London Capital & Finance (LC&F), has left around 11,500 small investors facing heavy losses on the £236m they invested with the firm. Southampton-based LC&F advertised itself as a low-risk individual savings allowance (ISA) that promised to spread funds between hundreds of companies, but its product was in fact a high risk mini-bond focused on 12 firms.

Following the January failure, administrators Smith & Williamson released a report which uncovered a number of "highly suspicious transactions" at LC&F involving a "small group of connected people" which led to large sums of investors' money ending up in their "personal possession or control". Investors are expected to lose 80 per cent of their investment.

The Serious Fraud Office opened an investigation into individuals associated with LC&F, and earlier this month made four arrests.

And yesterday, the FCA said it will look into “whether the existing regulatory system adequately protects retail purchasers of mini-bonds from unacceptable levels of harm.” At the same time the government has ordered an inquiry into the FCA’s supervision of LC&F.

What is a mini-bond?

A mini-bond is a form of corporate debt that allows backers to invest in a company and receive a fixed return over a set period of time, with the initial investment returned at the end of that period.

How does a mini-bond differ from a normal corporate bond?

A mini-bond runs for a shorter period of time, typically three to five years. A corporate bond can run for ten years or longer.  

Also, corporate bonds are traded on stock markets around the world over their duration. In London, they are bought and sold on the London Stock Exchange’s Orb market.  

However, mini-bonds are not traded on exchanges, and investors have to hold them for their full term. As mini-bonds are not listed, they are allowed to disclose less information than a traded bond to investors.

Are mini-bonds more risky than other bonds?

Yes. They pay much higher rates of return than normal corporate or government bonds, because investors are being compensated for taking on higher risk.

An investor may invest £1,000 in a four-year bond with an interest rate of 8 per cent a year. The investor will receive £80 of interest each year, before tax, for the next four years, making a total of  £320. When the bond matures the investor will also get their original £1,000 back. This is if the firm does not got bust during this period. Bondholder payouts come behind a number of other creditors a bankrupt firm owes cash to.

However, mini-bonds can pay up to twice as much as corporate and government bonds, unless investing in a particularly risky company, or a nation under economic stress.

Have these types of bonds become more popular?

Yes. Particularly with smaller firms who have found it difficult to raise cash from banks since the 2008 financial crisis. Some small businesses have turned to peer-to-peer lending, while others have sold debt directly to the public through mini-bonds.

Department chain John Lewis, confectioner Hotel Chocolat and Mexican restaurant chain Chilango have all sold mini-bonds in recent years. Some offer novel inducements to encourage investors. Hotel Chocolat sends chocolates to bondholders, while Chilango gives away free weekly burritos.

Given the poor return on savings, investors are searching for higher yields. But potential backers should not be fooled, mini-bonds are for sophisticated investors who know their way around a balance sheet and can assess how much profit a company makes against its existing levels of debt.

Are mini-bonds covered by the Financial Services Compensation Scheme?

No. This scheme covers a number of financial products across banks, building societies, pensions and investments up to £85,000.

But not mini-bonds. ISAs, however, are covered by this scheme. Confusion over how London Capital & Finance marketed its mini-bonds as ISAs will be looked at by regulators.

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