With many interest rates now in their eighth year below 1%, advisors remain hard-pressed to find low-risk sources of significant income. Online-only bank accounts may pay 0.90%. Five-year CDs are yielding 1.64%. And 10-year Treasurys recently traded at 1.46%.
Stocks are a superior source of yield. That’s a key reason the equity market has been making new highs. But for investors focused on capital preservation, equities are not the right place to park all their money.
We’ve written about the appeal of preferred stocks. These are dividend-focused securities whose prices move in concert with interest rates. The main drawback of these issues is that most don’t mature. So if you need your money in several years, and rates do start moving up, then you may be in for a haircut if you sell.
Securities that get mixed into the discussion of preferreds are “baby bonds.” These are exchange-traded debt issued at $25. You can easily buy and sell them online like stock. They mature on set dates. Most important, many are investment-grade senior debt offering attractive yields.
Haven’t heard of them?
No surprise. The space isn’t very large—only about $25 billion. Few advisors know about them. Financial papers don’t write about them. And while big-name brokerages underwrite them, very few cover them. Baby bonds are an obscure asset class, even though from a safety perspective, they rank alongside their traditional $1,000 brethren in the capital structure.
Reaching Retail
Baby bonds were created several decades ago to expand the investor base of creditors to retail investors. Issuers like them because they are flexible debt, with call features that kick in five years after an offering, payable at par; $1,000 corporate bonds, on the other hand, tend to be much more expensive to buy back for the issuer because they are designed for high-end investors and institutions looking for long-term yield plays.
Corporate debt pays interest semi-annually, involving much larger issues that trade over-the-counter with wide bid-ask spreads. Baby bonds make quarterly interest payments, trade like stocks and involve issues that typically range in size from $30 million to several $100 million.
Industries raising revenue in this market include financials, shipping, industrials, utilities, energy and retail. And the issuers include some very big names: Goldman Sachs, GE, eBay and Hartford Financial.
A helpful, free website that provides essential data is quantumonline.com. It lists nearly 200 issues, identifying call dates, maturities and yields, along with access to prospectuses.
So what’s wrong with them?
Nothing, except that retail investors have poured into baby bonds since late winter, making many expensive. This means that even with many bonds offering attractive yields, new investors have to watch out for negative net returns if the bonds are called. That’s because they are trading so much above par. Kevin Conery, analyst at Piper Jaffray’s preferred trading desk, suggests buying new issues around par with initial call dates many years out.
Credit risk is largely informed by the health and prospects of a company (and its industry) and rank in the capital structure: senior unsecured down to subordinated debt.
Caveats
Like any investment, advisors need to know the issuer and its industry. They must check the bond’s maturity, which can range from less than a year to a century.
Buying above par isn’t necessarily a bad thing. Just make sure you can’t lose more when the bond is called than you gain on interest collected. Greg Phelps, senior portfolio manager at John Hancock Asset Management, who runs several billion in preferred stock mutual funds (which includes a bunch of baby bonds), says this is a key issue because “more often than not, baby bonds are called at or soon after the initial call date.”