Bonds for all

Have you ever wondered why bond exposure is so often achieved via bond funds and not through direct investment?

by Sir John Royden

Head of Research


It’s because direct access by private or retail clients to most bonds is limited due to a minimum ticket size of £/$/€ 100,000. These are institutional bonds that trade in the so called wholesale market.  

Private clients can trade government bonds such as gilts and US treasuries in small “retail” sizes of £/$ 100 or more and corporate bonds on the ORB (“Order Book for Retail Bonds”) in small sizes from £/$/€ 100 and upwards.

There are other bonds in retail sizes but they are few and far between and tend to be issued by supranationals like the European Bank for Reconstruction and Development (“EBRD”).

It has been a personal ambition of mine to expand the retail bond market, not least because it gives us the opportunity to avoid funds’ management fees.

The first problem is that fewer than 60 issues are listed on the ORB and that is an un-investably small universe, despite many household names like Vodafone, SSE, Barclays, Lloyds, Legal & General and Severn Trent having bonds listed there.  Second, there tend to be uncomfortably large bid / offer spreads averaging 4.7% vs 1% in the wholesale market.  Traded volumes are low as well.  This is due to some issues being small; a third of the 60 issues on ORB are sub-£100 million in size.  Added to which many retail investors on ORB tend to fall into the “buy and hold” category which limits volumes that get naturally traded.  

Some of the ORB’s issuing companies are un-rated, possibly due to the £100,000+ cost of a rating.

The depth of the ORB market could be improved.  The size you can deal in on the price shown is called a clip and on ORB, £25,000 clips seem to be quoted.  Contrast this with clips of £ hundreds of thousands to £ millions in the wholesale market.  

Some of the ORB’s issuing companies are un-rated, possibly due to the £100,000+ cost of a rating. This adds work, time and cost in assessing the suitability of the investment decision.  Many bonds are from un-quoted companies which increases the cost of ownership (time spent learning about the company).  Standardisation of prospectuses is improving.  ORB, along with the wholesale market, has had its fair share of awkward and time-consuming corporate actions and maturity extensions.  

Why does all this matter?  Exposure to bonds via funds misses the qualifying corporate bond capital gain tax exemption. Direct holdings allow investors to implement their investment strategy as well as avoiding a 0.6% fund management fee. Direct holdings also allow you to match maturing bonds with liabilities and avoids you being tied to a bond fund manager. Conversely bond Exchange Traded Funds (ETFs) tend to have a costly and performance eroding high churn rate with lots of bid / offer spread being paid as bonds move out of the ETF’s maturity profile.

As far as issuing companies are concerned, a retail bond market theoretically opens up a new pool of liquidity as well as publicising its equity which is good for listed companies and companies considering a listing.  ORB is good for small deal sizes (below the institutional minimum of £250 million for investment grade bonds) and can allow the issuer to spread out the maturity profile of its debt over time.  

Some argue that ORB issues need higher interest rates to attract retail investors but I think this is probably attributable to the illiquidity premium.  Some corporates also think that there is a higher standard of care for retail investors and extra cost of preparing retail bond prospectuses for regulatory approval but I disagree with this.

Many bonds are from un-quoted companies which increases the cost of ownership.

Some companies remember Aviva’s attempt to cancel its irredeemable preference shares and Lloyds Bank’s attempt to force investors to sell their ECNs (a type of bond) and ask if the greater retail ownership of the Aviva preference shares was why the court decided against Aviva but for Lloyds Bank with its greater institutional ownership. Irritatingly, investment bankers articulate a frustration with retail investors and tell corporates that retail bonds are hard and more expensive to get placed.  

It is true that institutional bonds are easy to place with institutional investors where bankers can achieve a high speed of execution. It is also probably true that retail issues increase the work and time needed to contact more investors and then to gather their responses.  Institutional bond issues may require just 30 phone calls / road show meetings per issue.  Indicative soft demand from institutional investors is reliable whereas wealth managers are not so good at living up to their indications.

It is true that institutional bonds are easy to place with institutional investors where bankers can achieve a high speed of execution.

Bankers also mention that complex corporate actions might increase the risk that retail investors say that they have not been treated fairly.  But to date, there have been no such instances. In fact, several corporate actions have occurred that included both retail and wholesale investors such as Land Securities, Ladbrokes and Nationwide Building Society.

In the old days of mostly phone based trading, market makers liked the larger size of institutional orders but now that bond trading is becoming more electronic, on Tradeweb, this should enable smaller deal sizes.

ORB’s advantage is that it has market makers (Winterflood, Canaccord and Peel Hunt) making two way prices in contrast to the wholesale dealing which is more a mixture of agency (a broker bringing together buyers and sellers) mixed with market makers.  

So, there are multiple hurdles to cross in order to grow retail access to corporate bonds and, wherever the opportunity presents itself I do my best to enhance the investment universe available to our clients.  The first step would be to lower the minimum denomination size for electronically traded bonds.


Illustration by Matt Glasby

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Summer Issue Thirty Nine