Is This Hybrid Income Investment Too Good to Be True?

Kristin Orman By Kristin Orman, Research Analyst, The Oxford Club

Bond Investing

I like my adult beverages. And I’m partial to beer.

But that doesn’t mean I don’t like variety.

Luckily, I live within walking distance of three local microbreweries. So I try several different specialty brews each month.

When it comes to investing, I’m partial to income. And – like my beer – I like a little variety when it comes to my sources of that income.

It’s called diversification.

Diversification is a technique that manages risk by dividing investments among different strategies, industries and financial instruments.

With today’s low interest rates, income investors have traded in lower-yielding financial instruments, like certificates of deposits and savings accounts, for higher-yielding dividend stocks and corporate bonds.

But these securities aren’t your only options for generating income. And one lesser-known alternative is a hybrid of the two.

It’s called a baby bond.

Pint-Sized Exchange-Traded Debt

These securities are called baby bonds because of their size.

Baby bonds are issued in smaller denominations than corporate bonds are. Many of them are issued as low as $25.

Corporate bonds, on the other hand, are purchased with par value of $1,000. Due to their hefty price tag, these are often out of reach for regular investors.

Baby bonds, also called exchange-traded debt, trade on public stock exchanges like stocks. They don’t trade in the bond market.

This gives investors a way to enter or exit their investment if their needs change over time – just like a stock. They have ticker symbols instead of CUSIP numbers like traditional bonds.

But these pint-sized notes are debt issues. So they are senior to preferred and common shares in the case of liquidation. And baby bond holders will be paid their interest before regular and preferred stock dividends.

So they’re “safer” than owning the equity. Baby bonds also tend to have lower volatility than the stocks of their issuers do. Their prices fluctuate less.

However, most baby bond issues are junior to the company’s secured debt.

Crying for Yield

Baby bonds typically carry maturities of 30 years, although a few are just 10 years. These securities pay interest payments, not dividends, quarterly.

The coupon rates offered by baby bonds are generally fixed. And they are relatively high – many of them 5% or more.

And some baby bonds have investment-grade ratings (BBB- or above). This means that a ratings agency like S&P believes that the company is likely to meet its debt obligation. So investors will likely get their money back when the baby bond is due.

All sorts of companies, large and small, have issued baby bonds. Baby bond issuers include utility companies, investment banks, telecom companies, business development companies and many more. Some of these issuers are household names.

Online auctioneer eBay Inc. (Nasdaq: EBAY) issued a baby bond in February of last year. The name of eBay’s baby bond is eBay Inc. 6.0% Notes Due 2056 (Nasdaq: EBAYL).

Par value for eBay’s baby bond is $25, and the official yield is 6%. But since the security is trading above $27 today, the yield for new investors is lower – around 5.5%.

Interest is paid quarterly on the first of February, May, August and November. The notes are due in 2056 but can be called in 2021.

No Baby (or Investment) Is Perfect

But like any investment, baby bonds don’t come without traditional bond risk such as default or credit risk, call risk and interest rate risk. And because they are bought and sold on active exchanges, baby bonds face liquidity risk, too…

  1. Default or credit risk – If a company folds or goes bankrupt, investors could lose their entire principal as well as future interest income.
  2. Call risk – A baby bond has a call date, which is the earliest date the company can pay back the baby bond. If it is called, you’ll receive the baby bond’s par value, and interest payments will stop. Call dates are usually five to 10 years from the time the baby bonds are issued.
  3. Interest rate risk – When interest rates fall, companies will refinance as much of their debt as possible. If you buy a baby bond above par, you’ll incur a capital loss if the issue is called.
  4. Liquidity risk – The baby bond market is thinly traded. This means that few baby bonds exchange hands on a given day. Sometimes, only a few thousand of them trade. In a low-volume market, there is often a large spread between the bid (what a person is willing to pay) and the ask (the price at which a person is willing to sell). As with buying a low-volume stock, you’ll want to use a limit order to ensure you don’t overpay.

Also, you’ll want to consider the solvency of the issuing company. You don’t want to buy a baby bond that is in danger of default.

And you don’t want to forget about taxes. Since the IRS considers baby bond distributions interest, they are taxed at the ordinary income tax level. The distributions don’t receive the same qualified tax treatment most dividends do.

While they aren’t perfect, baby bonds deserve a look. Who knows? They might make a nice addition to your income portfolio.

Good investing,