Why bonds are a boon for investors

FOLLOWING his appointment as the CEO of the London Stock Exchange (LSE) this summer, Xavier Rolet announced plans to open a retail bond market here in the UK. He said: &ldquo;There is a clear need, particularly in the SME sector, for a lot of companies to be able to tap the bond market, particularly for retail investors &ndash; and today there really isn&rsquo;t a clear mechanism that&rsquo;s transparent, with good technology.&rdquo; On Tuesday, the LSE announced that this market would open for trading on 1 February 2010. <br /><br />Why should a retail bond market now be in favour? In many countries, the corporate bond market is no longer the preserve of the institution. US retail investors have been active in bond markets for some time. Recently, both Japan and Australia have launched successful retail bond markets.<br /><br />This has much to do with changes to investor sentiment coupled with an aging population. Bonds are growing in popularity with investors, who were hard-hit by the dramatic falls in equities and other asset classes in 2008. Bonds are perceived to be a safer option. <br /><br />An aging population also has a role to play. As people age, the trend is to move out of equity investments and into fixed income. Between 1983 and 2008 the percentage of the UK population over 65 increased by 16 per cent &ndash; a rise of 1.5m people. By 2033 it is estimated that 23 per cent of the UK&rsquo;s population will be over 65. <br /><br />In the US, investment in bonds by both individuals and institutions is commonplace. Indeed, slightly more than $7 trillion of corporate debt is held by institutional and retail buyers, and it is estimated that US retail investors pour around $32bn annually into the bond market. A Securities Industry and Financial Markets Association (SIFMA) study from 2004 estimated that 6.9 per cent of all financial assets held by US individual investors were bonds. <br /><br />This is not the case in the UK, where the debt market is the preserve of the institution. The same SIFMA study estimates that bonds make up just 1.5 per cent of the average individual investor&rsquo;s portfolio. This is supported by statistics published in 2007 by the British Bankers Association, when it estimated that the average size of a trade in a FTSE 100 company was &euro;40,000. However, in the debt market two-way prices in AAA -rated bonds were offered up to &euro;20m in size. <br /><br />Despite the sophistication of trading platforms, bond markets in the UK still tend to be over-the-counter, with telephone trading and market rules established by standards of good practice. As they are structured in this way, illiquidity is the norm and the door is firmly closed on smaller retail investors. <br />With this uneven field for debt and equity issuance, the UK is losing ground as corporates are deprived of a funding option readily available to global competitors. <br /><br />Take Japan, for instance. While the global credit crisis slowed during the autumn of 2008, activity in Tokyo&rsquo;s retail bond market was brisk. In December alone seven companies rated at least BBB+ (investment grade with little risk of default) raised a total of &yen;600bn through the issue of retail bonds.<br /><br />The UK market will trade UK and European corporate bonds. The trading rules for this new market were published on 17 November. These rules seek to facilitate business in this new trading counter while responding to the retail need for transparency. Key among these rules are:firstly, the requirements for bargains to settle into Euroclear UK &amp; Ireland&rsquo;s CREST settlement system; and secondly, an electronic order book similar to SETs with continuous two-way pricing provided by market makers.<br /><br /><strong>IMMEDIATE DISCLOSURE</strong><br />The link between the dissemination of the information and liquidity has been established. The proposed trading rules for this new bond market include provision for immediate disclosure of prices and trading volumes, which should drive down the average size of trade. <br /><br />Information on each listed bond will be available free of charge and on-line. As the prospectus rules apply to a debt issue, investors should have adequate information and disclosure about the issuer and the terms of the bond so that they can make an informed investment decision. <br /><br />Market support for this new bond market is vital, but the mid cap broker sector may be reluctant to commit the required investment to establish the fixed income teams and research analysts needed to become active participants. One way to reduce the level of up-front investment would be for the LSE to extend its research partnership with PSQ Analytics to this new market.<br /><br />Once the market is established, participants have a responsibility to assist by educating investors about bond investment. This should remove some of the mystery of bond markets and enable investors to better assess whether a quoted price is fair. It should go some way towards mitigating the risks of the inexperienced investing in the unsuitable. <br /><br />Creating a retail bond market in the UK provides investors with choice while giving UK and European corporates access to a new pool of capital. Structured correctly, bond markets should come out into the sunlight and the retail investor should come in from the cold.<br /><br />Tim Stocks is a Partner and Head of Capital Markets at law firm Taylor Wessing