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Why are Woodford and LCF fine for retail, but bank bonds not?


The suspension of the Woodford Equity Income Fund and the collapse of London Capital & Finance show how retail investors lack regulatory protection. This is strange, when a source of safer returns — bonds issued by large banks — is often deemed too complex and risky for the ordinary person to invest in.

In fact, a lack of access to bank debt may explain the popularity for other schemes, at a time of continued low interest rates.

Mark Taber, an activist on behalf of bondholders, says that historically individuals with savings looking for some return might have bought subordinated bonds or preference shares from well-established banks and building societies. These are now hard to come by for retail investors.

Meanwhile, issuance from the London Stock Exchange’s Orderbook for Retail Bonds (ORB) is slow, although financial firms without the regulatory supervision faced by the big banks, such as Burford Capital and International Personal Finance, have still been tapping the market.

“What people normally invested in has been taken away,” Taber says.

The arguments made against retail investors holding bank debt are understandable.

Regulators fear it would make those banks harder to resolve. The European Banking Authority and the European Securities and Markets Authority warned of this last year. Any bail-in is politically contentious. In Italy, a pensioner whose investment in Banca Etruria was wiped out committed suicide.

Furthermore, subordinated bank bonds are complicated. Additional tier one bondholders lose their coupon if a particular accounting metric, the maximum distributable amount, is breached. And if the cost of funding for the bank worsens, it will be forced to extend the bond. Most importantly, AT1s can be bailed in depending on the capital ratio of the bank and supervisors’ assessment of its health.

This array of factors can leave even the most seasoned portfolio managers second-guessing.

Yet an alternative approach would be to treat retail investors as adults who are allowed to make bad decisions with their money. And while AT1s are fiendishly complex, other securities issued by banks, such as preference shares, tier two bonds and senior bonds, are more straightforward.

At least these types of issues, when coming from large banks, are liquid and highly scrutinised by institutional buyers. They are certainly less risky than ordinary shares, which are easy for retail buyers to obtain.

The P2P intervention

Compare this with the vehicles that, after recent events, look set to leave some individuals nursing severe losses.

The now-suspended Woodford Equity Income Fund got around a provision that only 10% of assets in a UCITS fund can be illiquid or unlisted by having some of the assets listed on the stock exchange in Guernsey. Hardly a transparently straightforward investment for retail.

Many of the top holdings in Woodford, according to an April 30 factsheet, are small financial firms, such as NewRiver Reit, Provident Financial and Amigo. These companies also face less stringent requirements than big banks.

The Woodford scandal came after the collapse of London Capital & Finance, which issued mini-bonds and was authorised by the UK’s Financial Conduct Authority, earlier this year. According to the Financial Times, some investors were led to believe they could receive compensation from the Financial Services Compensation Scheme, something that is still to be determined.

The proceeds from the mini-bonds were used to lend to small businesses. The administrators of LCF said in April that most borrowers had not given them comfort “with regard to potential substantial realisations from them”.

Now 24 MPs have signed a motion calling on Andrew Bailey, CEO of the FCA (and bookmakers’ favourite to be next governor of the Bank of England) to resign, “for presiding over the biggest financial scandal of recent years”.

Meanwhile, with a couple of exceptions, subordinated bonds issued by major European banks have provided little in the way of nasty shocks in recent years.

One way of managing individuals’ investments in subordinated bank debt could be to follow the FCA’s recent intervention in the peer-to-peer lending market, by restricting unadvised investors’ holdings to 10% of their investable assets. The FCA made the announcement after the collapse of property finance firm Lendy.

Retail investors have enough in savings to allocate directly to a particular instrument or fund. They may be considerably better off than citizens who just rely on assets invested through the pension fund linked to their employer. Pension funds receive far less sympathy when things turn sour.

However, if retail investors are to be shielded from the complex and the dangerous, it is not clear why that should include bonds issued by big banks.