What are $25 Baby Bonds?
They are a different animal, but once you get the basics, they are fairly easy to understand. In a nutshell, they are a bond issue, that trades exactly like a stock. It varies, but they typically pay 5% – 8% or more quarterly distributions depending mostly on how long the maturity date is and the quality of the issuing company. It’s called Exchange Traded Debt (ETD) because it trades on the stock exchange (as opposed to the bond market). You place your bid just like a stock. Unlike bonds, the original issue price for Baby Bonds (Par Value) is by definition $1,000 or less. However, the majority are issued at $25, and those are the ones this article is about. Think of buying a Baby Bond just like buying a stock that trades for around $25/share. With that said, many have set maturity dates (when they are required to pay the $25 back), and call dates (earlier dates when they can pay back the $25 if they want to). In the meantime, you get the dividend. So, it makes a lot of sense to buy the ones that are still trading around $25 or less, so you will get your initial $25 investment back (more if you paid less than $25), plus all the dividends (technically interest) in between (most are paid quarterly).
Baby Bonds are not the only types of Exchange Traded Funds, but the others are not the focus this article, so we won’t confuse things with that. That confusion is part of the reason Baby Bonds are not better known. We are going to focus on Baby Bonds with a $25 par value and a set maturity date (as opposed to the few that are perpetual). These are the vast majority of Baby Bonds, and are becoming more popular with investors. There is a page dedicated to them over on The Dividend Channel. The Yield Hunter has a list of Baby Bonds and info you can check out HERE. Quantam Online also has a page full of them, but there are some preferred issues mixed in. CLICK HEREto see them (you have to register, but there is no cost). If the issue says a bond or note at a $25 par value, it’s a baby bond. If it says stock, it’s not.
Baby Bonds are safer than preferred or common stocks of the same company because they are a bond. Bonds rank senior to stocks in a liquidation scenario. Many do have a provision to be aware of that lets them suspend the payments for 10 years. This would only occur if a company couldn’t pay the preferred stock shareholders, and was in very serious trouble. It’s kind of an obvious reminder to pick companies that you think will be around as long as the maturity date.
Why are Baby Bonds good potential income vehicles?
They pay out a substantial and consistent distribution for a finite period of time, and they have been less volatile than the stocks of the companies that issue them. Think of them as a certificate of deposit issued by a corporation instead of a bank. You give them your $25, and they pay you the interest on it till the maturity date or until it’s called. There are differences. When the maturity date or call date arrives, you are going to get $25 back. So, if you paid $24, it’s a great deal. If you paid $26, not so much. They are not federally insured like a certificate of deposit. They are bonds of corporations though, and so rank higher than common or preferred stocks in protection. There are, of course, other differences too, but those are biggies. Over the past 10 years, the Trailing Total Returns for the S&P index using the SPDR S&P 500 index (NYSEARCA:SPY) was 6.89%. If you do your homework, you can attain that kind of return or more, but still have the higher safety of bonds, and less volatility than stocks.
Terms and Things you might want to know: Ticker Symbols and Information Lookup
You can look up information about a particular Baby Bond with standard tickers. However, you can’t find them listed on every site, and you need to understand the information that you find. One site that seems to work for all of them I have looked up is MarketWatch. CLICK HERE for an example using the KCAP financial Inc. 7.375% Baby Bond that is due in 2019 (KAP). On Sunday 5/15/16, it said the dividend yield was 7.39% which was slightly higher than the 7.375% coupon. That’s because it was selling for $24.95 (which is a slight discount to the $25 par which gives you a proportionally higher dividend). So, if you had bought it at $24.95, not only would you get a 7.39% dividend quarterly (slightly higher than the coupon), but you would also get $25 back for every $24.95 you invested when it matures in 2019.
The Price – This is a relatively thinly traded market. So, be careful when placing an order. In a thin market, there can be large bid and ask spreads. If the last price a Baby Bond sold at was $25, the current asking price could be $25.50, which is what you might pay if you place a market order. If the last price was $25, and that is the price you want it at, place it as an order with a limit of $25. Since they do trade thinly, you might also want to try to get it with a “Good until cancelled” order of $24.75 or something else less than $25. You just might get it at that price if you are patient. The price fluctuations (volatility) of a Baby Bond are typically less than the common stock of the underlying company. It isn’t as if you have to hurry and jump on the bandwagon (except in the case of the higher risk ones which we will talk about later – Mostly energy and shipping related).
Coupon Percent – This is the yearly distribution the security pays. If you bought it for less than $25, your dividend will be proportionally more. If you bought it for more than $25, your dividend will be proportionately less. I suggest checking the MarketWatch information for the yield based on the current price, and only buying Baby Bonds priced at $25 or less.
Earliest Call Date – This is the earliest date the company can pay back the $25 you lent them. If the security is called, you get $25 back. The security can be called anytime between the Earliest Call Date and the Maturity Date.
Maturity Date – This is the date the bond is due, and the company owes you $25.
S&P Rating – Some Baby Bonds have investment grade ratings (BBB- or higher) meaning that S&P believes the company is likely to meet the bond payment obligation. However, a large percentage have no ratings at all. For example, Baby Bonds that are issued by Business Development Companies (BDCs) sometimes don’t. This is commonly (but not always) because BDCs are not always huge companies, and do not want to be burdened with the large expense involved in obtaining the rating. The bigger BDCs are more likely to pay the price and get the rating.
Because many are unrated (which doesn’t necessarily mean bad), the way that I think about Baby Bond safety is in the perspective of how likely they are to continue some level of dividends on their common and preferred shares. Because the only way they can default on a Baby Bond is if they stop paying on all of their common and preferred shares first. So, if you believe a company has the strength to continuing paying some level of stock dividends (even if they are cut) for the length of maturity of the Baby Bond, it’s worth consideration.
Tax Treatment – I am no tax expert, but it is my understanding that non-municipal Baby Bonds are considered debt and that money you receive is considered interest, as opposed to dividends. So it is taxed at ordinary tax rates.
SOURCE: SeekingAlpha.com
