$25 Baby Bonds For Dummies Guide - Low Volatility High Yield Distributions, Safer Than Preferreds, And Commonly Overlooked Plus Some Picks

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Includes: ABR, EBAY, JMP, RAS
by: Dividend Don

Summary

$25 Baby Bonds for Dummies Guide.

Low Volatility, High Yield Investments.

Safer than Preferred Stocks, and Commonly Overlooked.

My Focus and Thoughts

My investment focus is on income with higher yielding dividend vehicles. If they have growth potential, it's a plus. I search for investments with a yield greater than 5% that have a level of risk that I deem acceptable (everything has some risk). Please note that I am not an investment advisor. You should always do your own due diligence with any investment. My goals are to share what I learn in reader friendly language, and to make investments that help me to go "Where the Warm Wind Blows". More on that later.

Note

In this article, the terms dividends, interest, and distributions will be used interchangeably (think of it all as income). We all know there are differences, but for the purpose of this article, we are going to think of them as income you might receive. So, let's not over complicate things with semantics.

Baby Bonds for Dummies Guide - No this title hasn't been copyrighted yet either (Click here to read my Closed End Funds for Dummies Guide)

1) 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 HERE to 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.

2) 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.

3) 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.

OK Dividend Don, let's talk more specifically

Here are some ideas to get you started thinking about baby bonds. Then you can use the resources suggested above to sort through the choices.

1) Total Speculation - There are a number of higher yielding issues that I consider very speculative. They are mostly in the Oil & Gas and Shipping sectors. I ignore them, but if you believe the energy sector and/or shipping sectors are going to make a rebound, they could be worth looking at. Understand that you could make a huge return (some sell well under the $25 par value), and you could also lose all of your money as the viability of some of those companies is in question, particularly if there is another big oil price downturn.

2) Special Situations - There are some Baby Bonds issued by companies that have common stock dividends that may be cut or have been cut, and the companies have had a rough ride. The Baby Bonds are more risky than most, but maybe not as risky as you might suspect. Remember, all of the common and preferred dividends would have to be cut completely, before the company could consider deferring or defaulting on a Baby Bond. Here is an example that I own and feel comfortable with.

RAIT Financial Trust, 7.625% Senior Notes (RFT). They have a call date of 8/30/17, and a maturity date of 8/30/19. As of Sunday (5/16/2016), the closing price from Friday was $21.39. What that means is that the yield was 8.91% till call or maturity, and that additionally, when they are called or mature, you would get $25 for each share that was bought at $21.39 (that's an additional 16.8%). I know. It sounds to good to be true. Right? Maybe not. The underlying company, RAIT Financial Trust (NYSE:RAS) has paid dividends on it's common stock, at some level, since 1997. RAS is a commercial lending REIT which you can read about in detail on their website. When things get rough, they cut back the dividend on the common, which they just did in January. They had a severe cut in 2008 along with many other similar companies, but always paid something. They have had a rough road, but I think the likelihood of suspending all dividends on preferred and common stock (which would have to happen first), and then defaulting on the Baby Bond is relatively low, especially before the 2019 maturity date.

3) Where the Warm Wind Blows Investments - That is what I call investments that don't worry me much, and provide a higher yield steady income stream to help me find my place in the sun where the warm wind blows. CLICK HERE to listen to a song I wrote with my musical partner Lola de Hanna about escaping to "Where the Warm Wind Blows". It is performed by our group, "The iBand". One of my other hats.

In the case of Baby Bonds, Warm Wind investments would be solid companies that have had minor bumps with the common stock that have kept the price of the Baby Bonds reasonable. These kinds of companies are very likely, in my opinion, to pay the Baby Bonds to maturity. They are the kinds of Baby Bonds I want to own. Here are examples of my Warm Wind investments.

Arbor Realty Trust, 7.375% Senior Notes (ABRN). They have a call date of 5/15/17, and a maturity date of 5/15/21. As of Sunday (5/16/2016), the closing price from Friday was $24.97. What that means is that the yield was 7.38% till call or maturity, and that additionally, when they are called or mature, you would get $25 for each share that was bought at $24.97. The underlying company, Arbor Realty Trust (NYSE:ABR) has paid dividends on its common stock, at some level, since 2004. RAS is a commercial lending REIT which you can read about in detail on their website. Their common stock pays a substantial dividend and there has been some talk for awhile about whether it would need to be cut. It hasn't materialized yet, but if it did, it would likely not be massive, and they are far from cutting the dividend completely. I think the likelihood of suspending all dividends on preferred and common stock (which would have to happen first), and then defaulting on the Baby Bond is very low, especially before the 2021 maturity date. In a recession like 2008 or worse, the odds would increase, but i can live with that.

JMPC JMP Group, 7.25 Senior Notes is a similar situation. They have a call date of 1/15/17, and a maturity date of 1/15/21. As of Sunday (5/16/2016), the closing price from Friday was $24.32. What that means is that the yield was 7.45% till call or maturity, and that additionally, when they are called or mature, you would get $25 for each share that was bought at $24.32 (an additional 68¢ gain/share). The underlying company, JMP Group LLC (NYSE:JMP) has paid dividends on it's common stock, at some level, since 2007. JMP is a full service banking and investment firm which you can read about in detail on their website. Their common stock pays a substantial dividend and they recently cut it when they earn less. This is the type of company that pays dividends based on how much they earn. Earnings were down, so they cut the dividend. It doesn't mean they won't continue to pay a dividend, and in fact it looks like their revenue and earnings per share are on the move up. I think the likelihood of suspending all dividends on preferred and common stock (which would have to happen first), and then defaulting on the Baby Bond is very low, especially before the 2021 maturity date. In a recession like 2008 or worse, the odds would increase, but I can live with that.

A lot of BDCs are in a similar situation and would made decent Warm Wind investments. Their dividends are variable rates based on how much they make. The market is very fickle and so the Baby Bonds sometimes drop when there is a dividend cut to the common stock, even though the Baby Bonds aren't effected. So, there are quite a few with Baby Bonds that yield 6 or 7% or so, and some are at or below the $25 par value. The KCAP Financial example mentioned earlier is one that I own and feel very comfortable with. As of Sunday (5/16/2016), the closing price from Friday was $24.95. What that means is that the yield was 7.39% on a 7.375% coupon till call or maturity, and that additionally, when they are called or mature, you would get $25 for each share that was bought at $24.95. I think KCAP and a number of the BDCs will be around for a long time unless there is a major recession, in which case I need to get out of everything early. Due diligence starting with the Dividend Channel page for $25 BDC Baby Bonds is strongly suggested on all BDC Baby Bonds and all Baby Bonds for that matter.

In conclusion: I suspect $25 Baby Bonds are going to get more popular as people understand them better. They are an alternative to Certificates of Deposit that aren't quite as safe, but yield a lot more. A good indication of this was in February when eBay (NASDAQ:EBAY) issued 40-year maturity $25 Baby Bonds with a 6% coupon (EBAYL). This may just be the start of them coming to market in larger numbers. Perhaps this article will inspire some readers to add some other Baby Bond ideas to the conversation. What do you think?

Disclosure: I am/we are long RFT, ABRN, JMPC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.