DBS

36 propensity for higher coupon rates 70 . In times of uncertainty, the demand for fixed rate bonds, debentures and loan notes tends to increase – the more secure the instrument is considered to be (asset backing, good credit rating of the issuer, secure income streams such as government guaranteed FITs), the greater the demand as a safe haven. This has the effect of increasing prices and compressing yields but can also create strong capital value growth. (Obviously, this will depend on awareness of the particular market and its liquidity levels.) This might be more pronounced if inflation rates stayed low, reducing the erosion of cash value that inflation produces. Rising interest rates might also mean new bond issues need to offer higher rates to make the risk premium worthwhile for investors. For this reason, bond rates and interest rates can move in similar ways. Rising borrowing rates might lead to an increase in crowdfunded DBS issuer defaults. Higher rates, encouraging saving and conditions which restrict cash in the economy could increase defaults, particularly at the higher risk end of the scale. However, platforms which have undertaken proper due diligence should examine a company’s interest cover ratio and debt service cover ratios, which reveal how comfortably it can repay debt and look to ensure there is some contingency to withstand any potential drop in revenue or asset value caused by this type of economic factor. Since more established DBS issuers may have financial performance information regarding similar periods, it could be easier to judge the risks for these types of entity in this type of economic environment. Nevertheless, the forecast is that the base rate will remain low for several years to come 71 . ‘Direct bonds’ allow saving on the fees of the dealer network, but can include additional costs, such as those related to marketing and the possible fees of other brokers, agents or intermediaries undertaking business development.” – OECD OTHER RISKS THE FCA’S VIEW The FCA cites these risks in its December 2016 Interim feedback to the call for input to the post- implementation review of the FCA’s crowdfunding rules FS16/13 (for both loan-based and investment-based crowdfunding platforms): it is difficult for investors to compare platforms with each other or to compare crowdfunding with other asset classes due to complex and often unclear product offerings: it is difficult for investors to assess the risks and returns of investing via a platform; financial promotions do not always meet the requirement to be ‘clear, fair and not misleading’; the complex structures of some firms introduce operational risks and/ or conflicts of interest that are not being sufficiently managed 72 . The FCA also stated that, “most of our attention at this time is on issues in relation to loan-based crowdfunding.” But the serious investment based crowdfunding platforms welcome regulatory scrutiny and consideration of new regulations, as a route to weeding out those in the market who are less focused on the best outcomes for their investors. INFLATION Inflation is an enemy of fixed income debt instruments, because rising prices erode the value of the fixed income they pay. That’s compounded by the fact that interest rates are usually raised to control inflation 73 . By May 2017, CPI had surpassed the Government inflation target of 2% at 2.9%, and in spite of an unexpected drop in June to 2.6%, the Bank of England has projected higher inflation to come in 2017 74 . However, whilst this EXAMPLE OF CROWDFUNDED BOND A company issues a £1,000 bond with fixed coupon of 8%. Every year, the bondholder will be paid £80. If interest payments are made on time and the bond appears robust, demand for the bond may rise (especially if a low interest rate environment prevails). After two years, the bondholder offers the bond for sale at £2,000, but the fixed coupon remains at £80, giving a yield of 4% (80/2,000). If the bondholder finds a buyer at £2,000, he makes a £1,000 capital gain plus 2 years of interest at £80 per year, giving a total of £1,160 profit. If many of his fellow bondholders also wish to sell their bonds, the competition for a sale could lower the potential asking price. And if there was very little interest, no sale might be possible, or a price lower than originally paid could be offered. This would give the purchaser a yield higher than 8% (e.g bond is sold for £500, but the income remains at £80 p.a. which is a yield for the new buyer of 16%) and the original bondholder a capital loss. This might be the case if interest rates in the wider economy went up substantially, perhaps to 10%, meaning no buyers would be interested at the original issue price because their yield would not justify any risk when higher rates may be possible from a bank deposit. Of course, it may be that there isn’t enough depth in the secondary market for the sale price of the bond to be significantly affected and if a sale were made, it might simply take place at par value. In fact, it’s also worth remembering that most DBS platforms do not have the ability to ‘trade’ bonds, and facilitate bids and offers, but instead only transfer bonds to other investors. Some people view this as a benefit as there is no market risk.