UK Bond Market Reform Set to Unlock Growth

Written By

James

UK capital market reform, retail investors and untapped potential

The UK’s capital markets are amid the most significant set of reforms for a generation. Free to change its regulations after leaving the EU and driven by concern about the performance of its capital markets, the UK government commissioned the UK Listing Review[1]. Published in 2021, this made a number of recommendations that are in the process of being taken forward, all designed to make the UK a more attractive place in which to raise capital – and its markets more accessible for retail investors.

The drive for retail accessibility is partly spurred by changes to the pension landscape and the rise of user-friendly tech-enabled investment platforms which have increased demand from retail investors who are much more engaged with managing their own funds than twenty years ago. It is also partly spurred by the realisation of the untapped potential that retail investors present.

By some estimates[2], the value of the UK retail investing market has grown to over £4 trillion since 2005. To say this represents a material pool of capital that could be accessed by companies is an understatement. In the UK at least, approximately 20% of household assets are invested in financial securities[3]. This compares to 43% in the USA[4]. Unlocking access to more retail capital, could help businesses raise the funds required to meet their goals such as expansion, net zero transition and digital transformation, whilst also boosting household finances and employment opportunities. No wonder the initiative has received strong, cross-party political support.

Corporate bonds, barriers to retail access and proposed reforms

Currently it is easier for UK individuals to invest in equities, crypto-currency, or to bet on a horse, than to invest in a blue-chip, investment grade, corporate bond. This is ironic, given that bonds sit at the safer end of a company’s capital structure, whilst UK retail investors are over exposed to higher risk equities. Bonds are crucial products for investors to have access to. In contrast to equity, they can provide a means of capital preservation (via investment repayment at maturity), together with a regular income from interest payments. These features are helpful for investors making financial plans – equities for capital growth and bonds for cash flow and capital preservation. Whilst investors can access bond funds, these do not serve as an adequate replacement for direct bond investment because the visibility of an individual bond’s maturity date is lost. This does not support investor planning and also changes the behaviour of the investment, encouraging selling during times of depressed prices. Funds also contain value eroding management fees.

A key barrier to UK retail access to corporate bonds is regulation, in particular the UK’s EU inherited Prospectus Directive, which was rolled out in 2005. Designed to protect ‘retail’ investors by requiring additional disclosures for bonds denominated under 100k, the effect was to exclude them, as issuers chose the easier route of using high denominations and issuing to institutions (the wholesale market). Low denomination bonds that UK retail investors can feasibly purchase, have declined by 99% since that date.

The regulator (the UK’s Financial Conduct Authority – ‘FCA’) is unhappy with this outcome. They believe that retail investors are better protected by investing alongside institutional investors. Free from the EU and encouraged by the UK government for the reasons above, initial proposed reforms were published by the FCA in 2023[5] and contained two elements:

1. To remove the need to have a retail AND wholesale prospectus, such that only ONE will be required; and

2. For seasoned investment grade bond issuers who decide to use low denominations, to be subject to even fewer disclosure requirements than currently required when they use high denominations (in order to incentivise a switch)

The feedback on these proposals was published in December 2023 and was strongly positive. Detailed proposals are now expected in early Q1 2025, with implementation later in the year. The intention is for this reform, plus others, to sit under the “Public Offers and Admissions to Trading Regime”, which will replace the Prospectus Directive in the UK.

Another regulatory barrier has been the UK’s EU inherited PRIIPs regulation, which has had the effect of making any retail targeted bond, a PRIIP if it contained a make-whole clause (a fairly standard feature). Being classified as a PRIIP has meant that additional disclosures and documentation are required, which has also encouraged issuers to avoid retail investors.

The FCA has recognised this situation too and in December 2024 issued a consultation paper proposing that this will not be the case under the new CCI regime which is being set up to replace the PRIIPs regime[6].

Retail Investors – profile and significance

It is worth considering who we mean by “retail investors”. Of course, they are individuals. But these individuals are investing via financial intermediaries such as investment platforms and wealth managers, who are acting as aggregators of demand. In the UK, the leading investment platform is Hargreaves Lansdown with around £180bn assets under administration and the top wealth managers include Investec/Rathbones with c£110bn AuM, RBC Brewin Dolphin, with £60bn AuM and Killik & Co, with c£10bn AuM.

Understanding the size and composition of the retail investment community and how they interact with primary and secondary markets is significant for a number of reasons. Firstly, many issuers ‘fear’ the prospect of dealing with retail because they interpret this as having to deal with “thousands of individuals”. However, in reality, an issuer and its transaction counterparties will be dealing with a limited number of intermediaries (who also take on the responsibility of complying with Consumer Duty regulations). These intermediaries can be added to any new bond issuance process and post-issuance, investor communications and any bond amendments are handled via the same retail intermediaries. Secondly, by aggregating demand, these intermediaries represent genuine additive demand to the bookbuild process. And thirdly, largely thanks to the discretion granted by individuals to wealth managers, some of these intermediaries can move fast and act in the same timescale as large institutional investors.

Initial feedback indicates that just a handful of these intermediaries could provide as much as £100m to a benchmark sterling £250m bond primary issue within the 3-hour time window used for bond issues to wholesale investors.

In the context of a UK market, where many issuers complain of a restricted investor base (see below), the ability to access this retail capital could be nothing short of transformative to the UK corporate bond market.

Issuers and the case for retail inclusion

Expanding the sterling investor base and mitigating funding (and pricing) risk Consolidation amongst relevant institutions has caused concern that the UK debt investor base has shrunk in recent years, with a number of issuers reporting that the UK’s bond market is dominated by a few powerful investors, with negative implications for pricing and accessibility. It is for this reason that the current reforms could be timely.

Opting for low denominations provides an issuer with an additional material pool of capital that diversifies the investor base and provides a level of mitigation against funding and pricing risk (helpful during geo-political uncertainty). Those with a strong retail brand or a retail following in the equity market stand to benefit, as will those wishing to raise funds for social, green or sustainability projects, since retail investors are known to have an interest in investments with a social purpose

“Retail investors tend to be price takers” says Michael Smith, Head of DCM at Winterflood Securities[7], who have made six Gilt (UK government bonds) issues available to retail across investor platforms for the first time in the past year. “We provide access to new issue Gilts at the strike price that’s set by institutional demand. Retail adapting to a price-discovery approach is important because it is how the wholesale market works. Whilst retail are price takers, a firm retail order at the strike could give the syndicate and the issuer something to work with, potentially changing the pricing dynamics.”

“Low denominations will also have a positive impact on the secondary market,” says Smith. “Tax considerations incentivise retail investors, more than institutions, to purchase bonds when prices are below par, providing helpful demand to the market. This could narrow spreads, which will be reflected in primary market pricing. For issuers less well known to retail, the secondary market might also be how they choose to include a retail investor base – issuing to institutions in the primary market, knowing that retail investors can access the bond (and provide liquidity) in the secondary market.”

Simplicity, inclusivity, smaller bonds – and “taps”

Other benefits of using low denominations and broadening the sterling investor base include simplicity, ESG factors and the possibility of smaller bonds.

A materially expanded (and diversified) sterling investor base must be an attraction to those issuers in need of sterling who currently raise funds overseas in foreign currencies and use derivatives to swap them back to sterling. Overseas investors and complex derivatives are two headaches a business can do without.

“ESG is increasingly driving a company’s decision-making,” says Michael Smith. “It’s something we’ve witnessed at Winterflood in the UK equity markets.” Driven by an increase in retail ownership of equities and pressure from their financial intermediaries, retail inclusion in IPOs is now the norm. It is viewed as good governance to include them and questions are asked if they’re excluded. “This is a trend we expect to see repeated in the bond markets (once regulations allow)”, says Smith, “in fact, it is something we are already seeing in the Gilt markets, with the way the DMO has supported retail inclusion in its new issues over the past year.”

On the possibility of smaller bonds, Smith sees potential. “Generally, wholesale investors only want ‘liquid bonds’, which tends to mean a minimum issue size of £250m – but this liquidity is possibly driven by the use of high denominations and the investment policies of those large investors – introduce low denominations and a new investor base (retail investors) and this could change.”

“I don’t see why a large, well-known, repeat issuer with a programme couldn’t issue a sub £250m bond or even tap an existing bond [once the regulations change]” says Smith. “Retail intermediaries would go for these bonds and it wouldn’t exclude larger, wholesale investors either.” With respect to “taps”, Smith thinks that issuers embracing low denominations could use this mechanism as a way to access retail, as they get used to the idea of combining wholesale and retail investors. “One structure we think could work well is this: an issuer runs an institutional book, prices the deal and then immediately opens up a limited-size and fungible retail offer on the same terms with concurrent settlement.” Although retail can participate in a 3-hour fast bookbuild alongside institutional investors, this suggestion breaks the two investor groups into separate stages of the same deal. “This might be more appealing to some issuers who want to test retail appetite without impacting their institutional investors” says Smith.

Conclusions

There are therefore numerous reasons why issuers might switch to low denominations should the proposed reforms go through. Once other reforms are implemented, issuing into the UK should become more attractive. As the regulatory landscape changes, issuers will have other considerations, such as how to retain the goodwill of core institutional investors. They will also want to get comfortable that including retail investors will not adversely impact the execution of a transaction or the bond’s performance in the secondary market. Unlisted issuers may need to amend their investor relations’ functions.

Impact of reforms on the UK and elsewhere

Given the scale and strength of demand from retail investors and the benefits to issuers from their inclusion, the impact of the proposed low denomination bond (LDB) reforms could well be material.

However, the use of LDBs will still be voluntary. Thus, an issuers’ advisers will have significant influence. It is something that Smith is keenly aware of. “The last 20 years of regulations have led to the (UK) bond market being thought of as the preserve of wholesale investors, for whom it works well, being unimpacted by 100k denominations. It is possible to see a scenario whereby advisers could be reluctant to encourage issuers to use low denominations and give access to retail. This will be the right course of action in some situations. But for many bonds, you’d anticipate that an adviser would advocate ‘low denoms’: it’s a free option, increasing demand and enhancing diversity.”

Everything hinges on the content of the detailed LDB proposals, due later in January. Other detailed proposals aimed at making debt issuance in the UK simpler and cheaper were released in July 2024. Implementation is expected later in 2025. The impact of these reforms should be to improve the UK’s attraction as a place to issue bonds, and this may cause other capital markets to look at their own regulations and to implement improvements if they feel that they are being competitively disadvantaged.

An example of such a market is the EU, where the lost opportunity caused by the exclusion of retail investors, is increasingly being recognized. Advocates for change point out that in 2021, just 17% of household assets in the EU were held in financial securities[8]. Should the EU implement regulatory reforms that unlock this capital, then the region will stand to benefit from deeper capital markets that support economic growth and increased household wealth.

“We won’t know how much of an impact the re-introduction of retail into the UK bond market will have until the regulatory reforms are known” says Smith. “If the detailed proposals are as we expect, incumbent investors may need to accept competition. You’d imagine that will be good for issuers. Retail investors will have to accept the increased pace of execution and price discovery in the primary market – as they have done with Gilts and equities. Ideally, issuers will include retail in the same primary book as institutions, or perhaps sequentially with a fungible wholesale offer, followed by a retail offer. Alternatively, an issuer might use low denominations and distribute to wholesale knowing that this would give retail secondary market access.”

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