Exploring Investment Grade Baby Bonds

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Includes: AINV, ETR, GE, GS, MHLD, NEE, PBI
by: Tim McPartland

Summary

$25 Baby Bonds Come in Many Varieties.

Like All Bonds, Baby Bonds Come with Many Different Maturity Dates.

Longer Dated Bonds Carry Substantial Interest Rate Risk.

In an article on March 18th we wrote an article on reducing portfolio volatility by focusing on exchange traded debt issues (ETD or Baby Bonds). In particular we advocated that conservative income investors should take a look at the issues that are available that have a relatively short duration--5 to 7 years to maturity. While shorter durations many times have a lower coupon than those with much longer maturity dates, they also tend to have reduce volatility relative to interest rates in general. We wrote that article with our own preferences in mind--we like nice steady net asset values in our accounts (or at least as steady as possible), while earning a return that is tolerable to us. The only problem with focusing on the shorter duration 'baby bonds' is that the number of available issues is rather limited--just 45 issues.

In this article we will focus on another segment of 'baby bonds'--Investment Grade (as rated by S&P). This segment contains around 65 issues, but for this article we have removed some foreign issues as well as issues from government related entities, thus we are focusing on 51 issues. A handful of these issues have relatively short durations, but generally they are longer dated maturities. As one might expect you have many issues from utility companies such as various Entergy (NYSE:ETR) units and NextEra Energy (NYSE:NEE) as well as from financials such as GE Capital (NYSE:GE) and Maiden Holdings (NASDAQ:MHLD), Apollo Investment (NASDAQ:AINV) and Goldman Sachs (NYSE:GS).

We should note that an issuer of baby bonds has a number of choices when selling a bond issue and one of those choices is how much interest rate risk they want to take (just as an investor has this choice). The issuer has to determine what they believe their refinancing interest rate will be when a outstanding debt issue matures. Will rates be higher or will they be lower? I think it should be obvious that when looking out just 2, 3 or 5 years a potential investor in bonds is going to be willing to accept a lower interest rate because they have a date certain that is comprehensible (or maybe I am just dense and have trouble comprehending a maturity date in 2070 when I will be 120 years old). Just like in the case of a government bond that matures in 10 years that has a coupon of 1.97% the longer dated bonds with a 30 year maturity has to have a higher reward--in this example 2.55% (either way the returns are lousy).

In investment grade corporate baby bonds a couple of issues from Pitney Bowes (NYSE:PBI) are prime examples of differentials in coupons dependent upon maturity dates.

Pitney Bowes 5.25% Notes PBI-A $25.63 5.25% 5.12% 11/27/2015 11/27/2022 BBB
Pitney Bowes 6.70% Notes PBI-B $26.88 6.70% 6.23% 3/7/2018 3/7/2043 BBB

These 2 issues were issued about the same time. The PBI-A issue was sold in November, 2012 and the PBI-B issue was sold in March, 2013--5 months later. General terms of the issue are near identical, excepting the PBI-A issue has just 3 years until an optional call date and the PBI-B issue has 5 years. And you will note that coupon on the shorter dated issue is 1.45% below the longer dated issue. Obviously these 2 issues fit the needs of both the issuer and potential investors. There was no problem selling the issue with a maturity date in 2043 so certainly someone liked the longer dated maturity with the corresponding higher coupon and interest rate risk.

Below is a chart with 51 investment grade baby bonds. All of these issues are $25 issues (closing prices of 3/27/2015).

From this list it is easy to peruse the issues that are available. The majority of these issues have maturity dates that are more than 25 years in the future. The coupons range from 4.70% to as high as 8.25%, while current yields range from 4.82% to 7.81%.

Just like preferred stock one should make every attempt to purchase these shares at or below par--or worst case at par plus accrued interest. Certainly this limits your selection, but your returns will be lowered (the yield to worst) if you buy much above these prices and the bonds are called early.

We note looking at the chart that the majority of issues enter their optional call date period starting in the next 1-3 years. This certainly should be a factor for anyone considering a purchase. For instance the Maiden Holdings Notes above have been great investments up until now as they have relatively high coupons. The problem is that they are all trading 6% above par and they enter their optional call periods beginning in 2016 (1 issue in 2016, 1 in 2017 and 1 in 2018). With everything we know today we would not touch these issues (although if you are currently holding them and have collected the tasty coupon for some time it is likely that you have time to continue to hold them) as they almost certainly will be called as soon as they reach their optional starting date.

Some of the issues above have very good liquidity, but most trade less than 20,000 shares a day. Investors have to pick their entry price, place an order and be patient. We have almost always been able to buy baby bonds at a price that is reasonable--but we may have to wait a day or 2. It should go without saying that if you try to chisel a nickel on the price you are probably being penny wise and pound foolish.

Now as we mentioned at this start of this article maybe some of these investment grade baby bonds are for you. Over the years whether it be on Seeking Alpha, or in the various chat rooms, we have observed the ongoing debate--is current yield most important or is net asset value most important? This should be a key consideration by potential investors. This is not a question that anyone except the investing individual can answer. It is dependent upon present and future needs, age of the individual, total income sources and on and on--no 2 investors are the same.

With all bonds interest rate risk is a very prime factor that must be understood. For instance if the 10 treasury goes to 5% in the coming years prices of bonds are going to fall dramatically--the pain will be excruciating to those concerned about their net asset value. Yes, the income will remain flowing at the same dollar rate as always, but how will you feel when your $25 bond falls to $12.50 (or $1000 bond to $500)? If you have not felt this pain before you should talk to someone who concentrated their assets in upstream Master Limited Partnerships (MLPs) as they have watched their assets evaporate. We don't believe that most investors (even us) can even imagine the emotions they will encounter when a lifetime of savings falls in value by 50%---it will happen--someday. The above issues must be part of a larger, diversified portfolio or potential disaster awaits the investor. No one can say when this will happen, but over the life of some of these longer dated bonds we will move through many interest rate cycles and prices will move sharply higher and sharply lower.

A review of the above segment of the baby bond market would not be complete without mentioning a provision of some of the issues above. A portion of these bonds were issued with terms that include a 'deferral period' that can be invoked by the company without triggering a default. This is equivalent to a suspension of dividends on a preferred stock. The deferral period can be up to 10 years (wow) and in some cases they are allowed to have multiple deferral periods during the life of the bond. If interest payments are deferred they continue to accrue (similar to a cumulative preferred stock) and must be paid at some point in the future. This is another reason why investors should become accustomed to reading prospectuses and registration statements--you are responsible for knowing details of issues you purchase.

While the above longer dated baby bonds may fit the needs of some investors we are not a buyer of any longer dated issues (beyond 10 years). Our Yield Hunter list of the shorter dated issues is adequate at this time to fulfill our needs, although we can imagine a point in time when longer dated issues might be palatable to us (when interest rates rise by a number of percent points).

In summary, there are baby bonds of many different types available to income investors, but one must recognize the risks that rising interest rates present to the longer dated issues. Investors should do adequate due diligence on any issue that is being considered for purchase, which includes the reviewing of prospectuses and/or registration statements.

As always we never recommend the purchase of any security as we cannot ensure the suitability of any investment for any given reader.

Disclosure: The author is long ARU.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.