Looking to add some bonds to your portfolio without sacrificing a decent yield? Baby bonds may be the way to go.
Conventional financial wisdom tells us bonds should make up a percentage of most portfolios.
The actual percentage varies.
If you're young, a smaller portfolio allocation of bonds is recommended.
If you're in retirement, you will probably allocate more of your portfolio to bonds.
What Exactly is a Bond?
A bond is a fixed income instrument that are debt obligations.
A company or government borrows money from an investor in return for a regular interest payment.
At the end of the bond maturity, you get your money aka principal investment returned in addition to collecting interest for the duration of the term.
Traditional bonds are not easy to purchase. The investment minimums – in price and quantity – can be high and searching CUSIP numbers isn't how most of us want to spend our time.
However, there is a subset of the bond market that we like a lot and report on regularly.
Introducing Baby Bonds
Exchange-Traded Debt Securities, also known as baby bonds, are small denomination bonds (notes) that are traded on a stock exchange rather than a bond market.
Most of them are $25 per share with 10-year to 30-year maturity.
When researching a baby bond, it is important to realize that what you are buying is a debt instrument issued by a company or government body.
After you pick a bond you are interested in, it is very wise to perform some kind of analysis on the issuing company.
Is the company a small ball bearing factory based in Michigan that is followed by financial analysts or is it a risky shipping company based in Bermuda with no information about it and a negative EPS.
Baby Bonds to Avoid
Shipping companies have a reputation for being inefficient, over-leveraged, and not very profitable.
Many companies in the industry operate with losses and are forced to fund activities through debt offerings.
Credit Suisse Global Investment Returns Yearbook has rated it as one of the worst-performing stock market sectors of the past 100 years.
Best to just stay away.
Baby bonds are subordinated debt and therefore will be repaid after senior debt, but before any equity.
That means it is the second lowest risk on the scale and is considered less risky than preferred or common stock.
In case of a default, baby bonds fall under subordinated debt in the following list of priority for repayment.
- Senior Debt
- Subordinated Debt (Baby Bond)
- Preferred Equity
- Common Equity
How Interest Rates and Duration Affect Baby Bonds
One important concept to remember when thinking about bonds is that as interest rates rise, bond prices fall.
And as interest rates fall, bond prices rise.
The lower the price of the baby bond, the higher the yield.
It also means that any change in the market interest rate will affect the value of a bond.
Interest rates are volatile. No one can predict when they will change or by how much.
One of the most important terms for a bond investor is duration.
It allows you to compare bonds with each other.
Duration does not reflect anything about the underlying company issuing the bond.
It measures the relationship between interest rates and the bond’s maturity/coupon.
Duration estimates the impact of a 1% change in interest rate could have on a bond’s price.
Higher the number, the higher the sensitivity.
On a duration of 5 years:
- If the interest rate rises by 1%, then the bond price would fall 5%.
- If the interest rate falls by 1%, then the bond price would rise 5%.
For most cases,
- If the bond has a higher duration, it will have higher interest rate risk.
- Bonds with high coupons have a lower duration, so they are less sensitive to interest rate changes.
Long maturity bonds usually have higher durations.
Low coupon bonds usually have higher durations.
So, all other things being equal, you would prefer a low bond duration.
Baby Bond Investing Tips
Payments from baby bonds are interest payments and are not eligible for the reduced qualified tax rate that are levied on dividends.
Many issuers of baby bonds are REITS and Business Development companies (BDCs).
BDCs typically have minimal price volatility and are usually well diversified.
No one company will dominate a portfolio, and they limit their debt-to-equity ratio at 1:1.
If you can buy a baby bond under the $25 par value, it will increase the yield that bond pays.
For example, at the $25 par value a baby bond may offer a coupon rate of 6%. But if you can buy the bonds for $24 – a $1 discount to par – your yield increases from 6% to 6.25%.
What are the Risks in Baby Bonds?
Many baby bonds are callable.
That means the issuer can return the principal and stop paying interest.
The company “calls’ them back. This means your baby bond pays off early and you have to look for another opportunity to put your money to work.
An investment is liquid if it can be quickly bought and sold.
Low liquidity means that it will be more difficult to find a buyer for your asset and you might be stuck with it.
You might have to sell at a discount if you needed to sell it quickly.
Interest rate risk
Interest rate risk is the possibility that the value of an investment will decline as the result of an unexpected change in interest rates. This is what duration helps to measure.
Credit risk is the probable risk of loss if a borrow fails to repay a loan or obligation.
Bonds are graded by their credit ratings.
The grades are a reflection of the issuer’s financial health and financial ability to make interest payments and repay the loan in full at maturity.
Investment grade bonds are considered to have a relatively lower risk of default.
Here's a List of Baby Bonds to Consider
If you are a lower risk investor, you probably want an investment grade rated baby bonds. These will require less research on your part.
Below are some recommendations for baby bonds from large companies.
The call dates are a couple years away and they are investment grade.
However, because they are less ‘risky’, the yields are relatively smaller than the next, ‘riskier’, set of recommendations.
Notice that TVC has a low duration relative to the others and it has no call date. It also has a higher S&P rating. It is much less ‘risky’ than its peers.
However, its 3.35% yield reflects its lower risk when compared to the others that are greater than 5%.
Also note that every one of these baby bonds (except AT&T) is trading at a premium – over par. If you purchase at a premium (greater than $25), your yield will be reduced.
These next set of recommendations have lower credit ratings and are from smaller companies. As a result, the yields are higher.
Notice the comparison between PBI-B and AIY.
They have the same S&P rating, maturity year, and call year.
Between these two baby bonds, PBI-B offers a higher yield at a lower duration.
MHLA offers a higher yield and lower duration, but with more credit risk.
When deciding on baby bonds, you have to determine your risk tolerance.
The Verdict on Baby Bonds
We like baby bonds here at the Income Investors. It's an easy way to add some exposure to bonds and regular interest payments without the usual bond investing hassle.