Property funds and bonds. Part 2
We continue our analysis of property funds and bonds by giving information on how you can benefit from a property without having to buy it directly.
During the first part of this article, we focused mainly on property funds and explained how they can be used by investors to invest indirectly into a property. We explained the advantages and disadvantages of property funds. You can access this article by clicking on the above link. This article also touched on REITs as a tax efficient structure for investing in property. REITs have been covered more comprehensively in a separate article titled UK REITs. What are they? And how do they work?
During the second part, we are now turning our attention to property bonds. We will explain what they are and how they work. We will also give you an insight into their pros and cons as an investment.
What are property bonds?
Property bonds are a way for developers or house builders to raise money from investors. This is in the form of a loan, to fund the development projects of the company.
A bond is a legally binding agreement between the investor and the property company. The investors’ capital is offered as a loan to the development company. There will be a contract between the investor and the company which explains the terms of the agreement.
Terms of the agreement – or bond offering
This is usually formalised in an investment prospectus. The document will outline the following:
- Annual percentage return. This is the interest the investor will receive per annum.
- Bond term. This will outline how long the company plans to borrow money for.
- Bond raise. This outlines how much the company is looking to raise.
- Bond security. This is the security an investor has over the company to protect their investment.
- Purpose of the bond. This will outline what the money is going to be used for. It will also outline how the company plans to pay the investors back.
How do property bonds work?
Bonds work by taking investors’ money and paying them a fixed annual return on their capital. The investor receives a return which is higher than they would get from a bank or building society and at the end of the term they receive their capital back.
Annual percentage return
The company needs to offer a higher rate of return than banks, or there would be no motive for investors to invest money with them. This is because, savings in the bank are guaranteed, but bond investments are not.
The bond term is the length of time that the company is planning to borrow the money. At the end of the term, the company must pay bondholders back in full. This means the company only has to service the debt interest until the money is due to be paid back. What then happens if the investor needs to liquidate their investment? The investor would need to sell the bond to another investor. And this brings us to the next point.
If the company is a larger entity and looking to borrow a larger amount of money, the bond debt can be traded on an exchange. This would allow bondholders to sell their debt if they needed. However, the capital value of bonds on the secondary market (stock exchange) can go up or down in value. This means if an investor does not hold the money until the end (maturity), they may not get their full capital (principal) back.
In contrast, small companies may look to raise money, but their debt capital won’t be listed on an exchange. This means that an investor will have to keep hold of the bond until maturity. Because of this, these types of bonds offer a higher rate and are usually only available to high-net-worth and sophisticated investors.
Bondholders enjoy a degree of security on their investment. They will take a formal charge over the assets of the company. So if the company doesn’t pay the investors back, they can seize the company’s assets. However, it is important to note that bank finance ranks higher. This means banks get paid back first and whatever is left goes to bondholders. Last in line to get paid back are the shareholders of the company, but they are investing for growth and not income.
How does an investor know what risks are involved? For larger companies, this work is done for them. Credit rating agencies will appropriate a score against the company to determine whether the company is likely to meet its debt obligations (bond repayments). This information can be found online. Good quality companies are considered investment grade, whilst companies that are not so financially sound will likely have junk status.
For smaller companies, which are privately traded, there is a lack of public information. This makes it difficult for investors to decipher investment risk. This is why the FCA restricts mini-bonds. Only experienced investors are permitted to invest in these smaller companies. As an investor, you should seek advice about bonds from an appropriately qualified investment professional. You can check an investment company’s credentials on the FCA register.
Purpose of the Bond
The property company seeks to raise bonds as a way of obtaining extra finance. This will allow them to do more developments to increase in size, to increase profits. Shareholders are usually happy for the board to do this, as it potentially can increase their return on investment.
some of the key terms are listed below:
- Coupon. This is your rate of return. Typically this is paid twice yearly, but can be paid annually or quarterly.
- Yield. This is another measure of your return. The yield can go up or down in value for traded bonds. If the capital value rises the yield will go down and vice versa.
- Par. This is the issue price. Usually, they work at a price of 100, but it can be any denomination. If the value rises the bond is said to be trading at a premium.
- Credit rating. This is the score that independent credit rating agencies give the company. The score lets investors know how likely the company is of meeting its debt obligations.
- Redemption date. This is the date the company must pay the loan back. Often it can be called the maturity date.
Advantages of property bonds
There are several advantages for investing in property bonds. We list the main ones here:
- Fixed interest rates. When you invest in a bond you know the rate of interest you get paid when you get paid it, and if you hold the bond until maturity, you know how much you are due to receive back.
- Asset-Backed. As an investor, your loan is secured against the assets of the company via a legal charge. This means you have more protection compared to shareholders.
- Exit options. You can exit by selling on the secondary market if the debt is traded. If it isn’t then many smaller bonds have windows where investors can exit early.
- Convenience. Like investing in property funds there is no having to buy the property direct. There is no conveyancing jargon and documentation that you have to contend with.
- A chance of capital gain. Many larger bonds trade on an exchange. Sometimes the value of the bond goes up if the market changes. For example, if interest rates go down your bond becomes more attractive to other investors. If this happens some investors decide to cash in early.
- Qualify for ISAs. Bonds issued by public traded companies can be put into ISAs by UK residents. This means your returns are exempt from taxation when put into an ISA wrapper. Unfortunately, unlisted companies do not qualify under current rules and regulations. Fees for bonds tend to be very low as well.
- Low entry level. Many bonds are available to invest in at low levels. Typically, they may start at £5,000 or £10,000. This makes property bonds far more accessible to investors.
Disadvantages of property bonds
Like all investments, property bonds have their disadvantages too. Below we list the major downsides to this type of investment.
No tangible asset. When you buy a property, you own it. This is not the case with a bond. If the company becomes insolvent, there is a chance could lose some or even all of your money.
Capital fluctuations if selling early. If a bond is traded on an exchange it is subject to market forces. This can make the capital value go down. Conversely, it may go up. However, this is the risk you take, if you are not prepared to hold the investment until maturity. Major causes of these fluctuations tend to be caused by a change in either the credit rating of the company or interest rate changes from the Bank of England.
Liquidity. for many of the smaller bonds there is no liquidity, as they are not traded on the market, so you can be tied in for a set period. Fortunately, these smaller offerings usually have a shorter maturity date.
No capital growth. Bonds are primarily an income generating product, so you are less likely to see a capital gain on your investment. This means that your money is likely to erode due to inflation, whilst investing in property directly tends to outperform inflation in the longer term.
Should I invest?
Investing in bonds can be advantageous. You don’t have the hassle of buying property direct. You are likely to receive a fixed income at regular intervals. This is what some investors crave. With this in mind, property bonds are suitable for investors who are looking to get a fixed return on their capital. However, bonds are not without risk, so it is important to do your due diligence before you commit.
For investors that are seeking capital growth, then there are better ways to invest your capital. At Esper Wealth our approach is to spend time getting to know you. This relationship building is not just about building trust. By understanding your investment objectives and attitude to risk, we are better positioned to give you advice which is tailored to your individual needs. This is why we offer a free investment review to all prospective investors. You can find out more about our investment approach on our about us page.