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Wealth Management 2005 from
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The game is bonds
" By Adrian Jones and Peter Smart
Brewin Dolphin Securities
The increased cost involved in making a prospectus compliant with the directive may affect the decisions of issuers to tap into the retail market and, if they do, the extra costs may be passed on to the investor – providing for a reduced return overall
A piece of far reaching legislation came into force in late 2003 although an implementation date of July 2005 meant that it had, until recently been almost completely overlooked. The legislation to which I am referring is ‘The EU Prospectus Directive’. This innocuous sounding, but weighty piece of European law has major implications for the bond markets of Europe and in particular on those investors it is designed to protect – the typical ‘individual’ or ‘private’ investor.
The principle of the directive is to introduce a single passport style prospectus that once approved in a single EU State, can then be used throughout the European Economic Area (EEA).
An issuer of bonds can then bring a bond to the market in any EEA country once they have met the initial prospectus criteria in another. This simplifies the process of issuing a bond, making it easier to raise funds throughout the entire EEA and more importantly it provides investors with a standardised Prospectus.
The directive distinguishes between two different classes of investor – ‘wholesale’ (professional investors etc) and ‘retail’ (the typical private investor). Issues aimed at the wholesale market benefit from a narrow range of disclosure requirements within the prospectus, while retail investors benefit from a broadened range of disclosure requirements.
On a practical point one of the main differentiations, between wholesale and retail is in the smallest amount that can be traded of an issue (nominal size). Wholesale targeted bond issues will have a minimum size of 50,000 nominal which is seen as a realistic bar to investment for retail investors. Retail investors should, therefore, be steered into those bond issues that have wide prospectus disclosure requirements.
There is a problem, however. Under the directive, the wider disclosure requirement increases the risk of litigation against an issuer of a retail issue. Simply put, each individual EEA state is responsible for deciding on civil and criminal liability breaches in respect of the bond and what is deemed as acceptable in one EEA state, may not be acceptable in another. Thus businesses face a heightened legal risk if they choose to issue bonds in the retail sector.
You can see what is coming next. Given the more onerous requirements laid out for retail targeted deals, it is likely that most bond issuers will find it in their best interests to avoid this market. Retail investors will find it increasingly difficult to find bonds to invest into in their segment of the market.
This in turn means their portfolios will become more concentrated in a handful of issues and will be at risk in terms of diversification – one of the key factors for successful bond investing. Further to this, the increased cost involved in making a prospectus compliant with the directive may affect the decisions of issuers to tap into the retail market and if they do the extra costs may be passed on to the investor – providing for a reduced return overall.
One may wonder why any company would bother to issue retail bonds at all, unless they are having difficulty with the wholesale market – ie there is a problem with the issuer.
Generally we expect to see less retail targeted bond deals. We expect that the volume of day-to-day transactions in the secondary market for retail bonds will also dry up. These factors will make it difficult for a retail investor to successfully construct a portfolio that meets their requirements. Something that up until now was relatively easy to do.
Peter Smart, Head of Fixed Income for Brewin Dolphin Securities adds: ‘There are some very apparent risks for investors remaining in directly held bonds, increased credit risk being the main one. The new directive exacerbates the problems of liquidity and reduced stock selection. In future the private investor may only have one way to go.
‘If you want to have an investment allocation to fixed income (and I strongly suggest that you do) you really should consider using a bond fund, unless you can meet the minimum criterion of the wholesale market, throughout your entire bond portfolio.
‘There are many fixed income funds to choose from and you will certainly be able to find something to fulfil your requirements. In fact the number of available funds and the choice they provide is in itself a problem. You will certainly need some assistance from your investment advisers.
‘At Brewin Dolphin we review many fixed income funds and have a wide ranging and involved fund selection process. Briefly, we look at exposure to credit and interest rate risk, what market the fund invests into, how the fund has performed against its peer group as well as over its life.
If this review produces a suitable result we interview the investment manager. Once we are comfortable with the fund in every respect and feel there is a particular area that it covers for which we do not already have a suitable fund, we will add it to our approved list.
‘Not many funds make it this far and there are thousands of fixed income funds to choose from, covering every aspect of the market. We provide investors with the best selection encompassing a range of funds that we believe will meet almost every investor requirement, ranging from UK Government bond funds (Gilt Funds) to high yield/emerging market debt.
We have recently added Global Index Linked to the range of fund categories. In addition to this we also run our own suite of fixed income funds, which have been designed with the local investor very much in mind.
‘All is not lost for the smaller fixed income investor, of course, you will still be able to buy some bonds but our feeling is that you will be better served if you broaden your approach to the market and really consider using bond funds as well.’
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