The pros and cons of investing in retail bonds

I want to show you the best ideas I can find to not only beat inflation, but smash it.

On Friday I introduced you to what could be a great place for some of your money. I told you about a bond paying over 12% interest and it struck a chord with readers.

That makes sense. The retail bond market has only recently become available to small investors. The concept is new to a lot of readers. And not everyone could grasp how this bond could be paying out 12% when, on the face of it, it should only be paying 6.5%!

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So today let me clear up some of the main ideas behind bonds. Too many people ignore bonds in favour of shares. But I think it's a vital area for investors. I don't want you to miss out.

I'll use the Enterprise Inns 6.5% December 2018 bond I mentioned on Friday to help answer some of the questions readers brought up.

Don't let your broker put you off

One reader says that his broker told him he'd need £75k to deal in this bond and that's "a great deal more than I had expected!"

The broker is wrong. In fact the minimum investment is 1,000 units. At a price of 75p a bond, that's £750 plus commission and accrued interest (I'll explain that later). So you can buy this bond in manageable chunks.

Next up, a couple of readers emailed to say they didn't understand how this could be paying 12%. So let me clear that up for you.

When the Enterprise Inns 6.5% December 2018 bond was launched back in March 2003, the world was a different place. The economy was what Mervyn King called 'NICE'. That is 'non-inflationary constant expansion'. It was a perfect time for companies to raise cash.

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Enterprise Inns took the opportunity. It issued a 15-year bond (effectively borrowing from investors) paying 6.5%. The bond pays investors 6.5% in interest every year. Then, all being well, in 2018 they get their capital back.

But remember, this bond trades on an exchange. That means holders can freely trade it. They can sell their bond, just like they could a share, to free up cash.

That's where things get interesting for us.

As I mentioned on Friday, the pubs game has been tough over recent years. We also had the credit crunch of 2008. So it's not surprising that many bondholders wanted to get out of their bonds. That caused the price to fall. As you can see from the five-year chart, at one point this bond fell to about 40p.

Enterprise Inns 6.5% December 2018

Source: Bloomberg

I wish this market was open to private investors back then. Man, that was a bargain!

As you can see, the bond's recovered. Yet today they're still only about 75p to buy. But let's work out the interest they pay

Each bond an investor owns receives a payment of 6.5p (split into two lots of 3.25p) a year. That gives us a running yield of 8.7% (6.5p/75p).

But of course investors should do better than that. Because on 6 December 2018 they should receive £1 back for every bond they hold, compared to the current 75p price to buy. That's a capital gain of 33.3% (ie 25p/75p) in just overseven years' time.

So how did I take my running yield of 8.7% a year, add in the 33.3% capital appreciation (inseven years' time) and come up with a figure of 12% a year?

Ah, now that's the easy bit. I used a bond yield calculator which is free and simple to use from websites like this one. Just put in the bond coupon, maturity date and the current price and the calculator will spit out the gross redemption yield (GRY). That is the annualised payment the bond is effectively paying out assuming you hold it to maturity.

If I buy now, can I get the December interest payment?

Another reader, Col, makes a great point: "...interest is paid every 6 months. The next payment being due on 6/12. So, in effect, could I get an almost instant 3.25% (based on face value, so in reality much better) by buying them in the near future?"

Unfortunately not. When you buy a bond, you effectively make two payments. First you pay the price quoted by your broker. And then on top of that you pay 'accrued interest' that is the amount of interest the bond has earned (accrued) since it last paid out.

That makes sense. Otherwise if, as Col suggests, you buy the bond just before it pays out, you're effectively nicking the seller's interest payment.

Why I love Enterprise's billion-pound pub portfolio

One reader questioned how safe a bond from a company in the pub sector is. And another pointed out that fixed interest bonds like this one can suffer if inflation takes off.

Fair points, both of them. Here's how I see things

There are many different types of bonds. Unlike equities which generally don't offer holders any security at all, bonds have varying degrees of security should the business go bust.

In the case of Enterprise Inns, if it fails to pay the bond interest or the final redemption, holders have the right to take possession of 503 specifically ring-fenced pubs - like a bank with a mortgage over a home.

These 503 pubs are currently valued at £1bn. That's 466% more than the £600m of bonds issued. Or to put it another way, the value of the pubs would have to fall 40% before bondholders get nervous. As I pointed out in Friday's piece, there are always risks with any investment. But I love the idea of having real, tangible property as collateral over the loan.

I understand that there's a paradox here, though. This bond offers real tangible security that's so hard to find in most financial assets. And yet the issuer is undoubtedly in a tough sector of the economy that may struggle in the years ahead.

But remember, we're alreadyeight years into the 15-year life of this bond. Seven years isn't such a long time to wait for your pay-out now. And we're starting off with an inflation busting 12% yield.

All in all, I think this is a great opportunity. But you'll have to assess whether it's a good deal for you. Today I hope I've answered some key questions raised from Friday's piece. If you're interested in this bond, be sure to read Friday's piece where I run through some of the risks involved too.

Look out for more bonds soon

There's certainly been a lot of interest in bonds frommy readers. And that's great. I think bonds are massively underused by private investors. I like shares too but the extra security offered by bonds means it's a must for a balanced portfolio. And they can be a great way to earn a good income from your money, too.

With inflation eroding the value of savings, I thinkit's time to take a bit more risk and seek out some higher returns in the bond market. If you're comfortable with that, get a decent broker that trades retail bonds. And keep reading The Right Side for help on building a portfolio of bonds for your future.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

Important Information

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.

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