Time to Publish a Baby Bond ($25 Debt Issue) Primer

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After writing on The Yield Hunter for 10 years, it is easy for me to forget that not every reader deals with income securities day after day. In that light, I confess to using terminology that isn’t always “user friendly,” particularly for the new reader. With this in mind, it is time to take a step back and review some basics on Baby Bonds (also commonly known as exchange-traded debt or ETD). For the purpose of this primer, we are addressing corporate bonds only.

Remember that a bond is the debt of a corporation (or a government unit) and bonds pay interest, not dividends. Thus, there is no preferential tax treatment for bond interest received. It is taxed at ordinary tax rates, while dividends can be taxed at a “qualified rate” (at a lower capital gains tax rate) under certain situations. Also, a bond doesn’t give any ownership rights in a corporation the way common stock would — you only have the right to receive interest on your holdings. As a baby bond holder, you stand in line before common or preferred stockholders with respect to a claim on assets in the event of bankruptcy.

“Baby Bond” has become our preferred term for debt issues that have a $25 par value (the value of the bond when sold and the amount that the issuer will pay for the bond when called or upon reaching maturity). Technically, the term baby bond would be any bond sold with a par value under $1,000. Similar to purchasing a common stock, you can buy one bond (or share) or you can buy 1,000 bonds (or shares) and just pay your normal brokerage costs. For us, the price of buying shares is just $7.95 per trade.

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You will note, if you review the $25 baby bond issues we follow, that they have names like “Notes,” “Senior Notes”  and “Jr Debentures.” While some of these terms are intimidating to some investors, the issues are all near identical in terms. The exceptions are the issues from some utility companies that have issued a limited number of “1st Mortgage Bonds,” which are backed by power plants or other property. Virtually all other baby bonds are unsecured (meaning they are not backed by specific assets of the corporation). It is important to remember that they all are senior in liquidation prefererence (in event of bankruptcy) to common and preferred stock ownership.

On a historical basis, most corporations have issued bonds with par values of $1,000. Individuals could buy these bonds through their broker or bank. Unfortunately, $1,000 bonds are not very liquid (liquidty is the volume of bonds traded daily). In fact, a particular bond may not trade for days and days. While some of these bonds trade on the over-the-counter market many times, you have to request specific bonds from your broker. In such cases, brokers will need to solicit offers to sell bonds from other brokers. In this manner, the bid/ask (the bid is what someone is willing to pay for a bond while the ask is what someone is willing to sell it for) may be very wide. That situation means the risk of over paying is great. For these reasons, our preference is to purchase baby bonds.

Baby bonds now are almost always sold with par values of $25 and trade either on the New York Stock Exchange or the Over the Counter market. This is why they are also called exchange-traded debt (ETD) issues. Typically, this means that the liquidity of any given issue is much greater than a standard bond. But the extent of the liquidity varies widely. One of the benefits of baby bonds is one can simply look up current price just like you would any common stock. On our recap page of baby bonds, one can simply look at the current price and then place an order in his or her brokerage account just as if a person was buying a common stock.

Another feature of most baby bonds is that they pay interest quarterly, while most $1,000 bonds pay interest semi-annually (twice a year). While there is little monetary difference between the two payment schedules, we personally always feel a “bird in hand is worth two in the bush” — better in our hands than theirs.

Like any type of bond, baby bonds may be “rated” by a major ratings agency (Standard and Poor’s, Fitch, Moody and in the case of insurance companies Best), but many are “unrated” in which case it is up to you, the investor, to make a judgement on the creditworthiness of the company without the aid of ratings agencies. 

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Most baby bonds have fixed “coupon” interest rates (the amount of interest that you, the bondholder, will receive and it is fixed for the life of the bond), although there are a few which are “fixed to floating rate” issues. In this case, the coupon rate is set at a fixed percentage rate for a number of years (for instance five years) and then converts to a floating rate which is adjusted based upon the level of a benchmark such as Libor, which is among the most common interest rate indexes used to re-set adjustable rate mortgages. There are even a couple of issues that are variable and adjust their coupon rate monthly.

Baby bonds, just like preferred stocks, almost always are able to be called early (before the maturity date) at par value ($25) plus accrued interest (the amount of interest earned since the last payment). This redemption period we call the “optional redemption period,” because it is optional to the issuer as to whether they will be called. This period almost always starts 2-5 years after issuance and the primary factor that will determine whether the issue will be called is the level of interest rates once the optional time frame starts. For instance, if a corporation issues baby bonds with a 7% coupon and five years later they are able to issue similar baby bonds at 5%, it is likely they will call the bonds and issue new bonds in a “refi” type transaction (just like refinancing your house mortgage when interest rates are lower than your current mortgage interest rate). Conversely, if interest rates move higher and the issuer is unable to sell new baby bonds at a rate below the 7% level they simply will not call the issue and will let it run to maturity (the fixed date certain when the bonds must be paid off).

Baby bonds have maturity dates and, like traditional bonds, these dates vary widely from two to 100 years. Issuers may want a shorter maturity date (we call this the duration of the bond) as they will be able to issue the bonds at a somewhat preferential coupon rate as the interest rate risk is minimized. A longer dated duration will have to have a higher coupon rate as buyers will demand to be compensated for the greater interest rate risk (the risk that rates will move higher during the course of holding the bonds) they will incur.

Baby bonds (and all bonds) with shorter durations will experience less movement in price than those with longer durations until maturity. This is simply a function of having a nearer “date certain” — the date when we know that we will receive our par value.

Some baby bonds contain a provision where the issuer can defer interest payments (postpone the payment) without causing a default event. Some of these provisions allow a deferral for as long as 40 quarters (10 years). This is obviously a negative factor and an issuer choosing to defer payments is likely to be punished severely. Unfortunately, the holder of the bond will be punished as well as one will take a major loss on their holdings as potential buyers will not be willing to pay anywhere near par value for bonds paying no interest.

Above we had mentioned that liquidity was one positive benefit when buying baby bonds. Unfortunately, while they are more liquid that traditional $1,000 bonds and “price discovery” (finding out the price of a given issue) is easier, many baby bonds still trade only 1,000-5,000 bonds (or sometimes called shares) daily. Because of this situation, one should always use a limit order (meaning entering a exact price you are willing to pay when ordering — if one was to enter a “market order” there is a good liklihood they will pay more than desired) when purchasing these shares. Additionally, one needs to have a level of patience when buying baby bonds. We find that it may take a couple days for an order to execute, but if your offer price is reasonable, you will eventually own some baby bond.

Next, when placing an order for baby bonds (or any stock or bond), use a reasonable order price. If you really want to own a issue does it make sense to quibble over 5 cents? Typically, we personally buy baby bonds in quantities of 300-400 bonds (or shares) at a time and 5 cents would make a difference of $15-$20 dollars — this should hardly be a deal breaker.

Lastly, it should be understood that Baby Bonds are bonds!!! It drives us a bit crazy when investors and writers continually call these issues preferred stocks. These are not preferred stocks — they may have some similar features, but would you rather stand in line with the debtholders or in line with the preferred shareholders in a bankruptcy? Certainly one should want to stand with the debtholders.

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