Baby Bonds: A Complete Review

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Includes: AGO, CTL, ETR, GE, ING, NEE, PFKAX, SO
by: Arbitrage Trader

Summary

All baby bonds sorted by various characteristics.

Yield curves.

How to separate baby bonds and sort them into the appropriate groups.

Author's picks.

Interest rate fear has us separating preferred stocks from bonds more and more these days. The main reason for this is their maturity date. In this article, I will try to give an outlook for the baby bond market in general.

Baby Bonds raw data.

We are talking about a market of USD 40 bln. As I write this article, there are 171 baby bonds trading on the exchanges that have not announced redemption. There are 99 companies that have their bonds listed on the exchanges. The size of the issues ranges from USD 1 bln to just as little as USD 8.2 mln (NEWTZ).

The largest issues are from companies like CTL, GE, NEE, ING, SO, ETR and are supposed to be priced with all the market knowledge available due to their high volume and credit rating. On the other side stand the issues from small BDC companies that are not rated, are tiny and offer a big risk premium to investors. On these charts you can see how the credit ratings are distributed among the group with their respective nominal yields:

A lower rating does mean lower nominal yield, which comes as no surprise. Where the alpha may be hidden is in these 65 unrated baby bonds, usually from small companies that get more attention at Seeking Alpha than anywhere else. There are several authors that I will recommend later that provide outstanding analysis for some of these low-volume issues. As for the rated ones, there are 80 baby bonds that are investment grade. The biggest problem they face is interest rate risk with yields at historical lows.

How to sort the baby bonds?

You cannot compare apples to oranges and this is why you need to put each baby bond in its appropriate group.

  • Baby bonds with negative yield to worst. Negative yield to call is something that has to scare away almost any reasonable investor. While this is true in theory, in practice there is a certain call risk you are willing to take. There are some baby bonds that are redeemable for quite a long time and while bringing redemption risk they are higher yielders with shorter duration. If you are capable of determining some redemption probability ratio, you may end up being invested in a lot of negative yielders and ironically enough it will make financial sense. Here is the list of these "bad" bonds:

AGO-E for example has been callable for more than 9 years. It is rated A by S&P and even though it has negative yield to call it needs to pay only 1 dividend to become a positive yielder. Its yield curve looks like this:

After receiving 2 dividends you will earn 3.5% annualized yield for holding less than 6 months. This chart shows that if you have any reason to believe that this stock will not be called soon it is a very good risk-reward ratio. In this particular situation the first one to be redeemed is AGO-B, so this lowers the probability of redemption even further. I am in no way recommending buying a negative yielder, but this one comes with a risk of losing 10 cents vs. the possibility of holding one of the highest rated baby bonds with 6% current yield.

  • Yield to worst being positive and years to worst are less than 5. This is the biggest group of baby bonds. Years to worst are calculated as the years in which the yield to worst is generated. They are seen in this very pretty chart:

It is really easy to spot potential research candidates on this chart, but it has one very big theoretical problem. Yield-to-worst is not always yield-to-worst. For example, it is very hard to compare a 3-year yield to call of 5% with a 25-year yield of 7.5%. Anyone who thinks this is an easy task should be able to benefit a lot from all the kinds in moves in the yield curve. I find this to be a really difficult task. Another note to be made about this chart is that I have excluded the 3 highest-yielding baby bonds because they need special attention. As I mentioned, the above chart may not be correct in predicting the life of these bonds and they may live as long as their maturity date allows them to, so let's move on to our next group.

  • Baby bonds with the shortest maturity, that have yield to maturity as their yield to worst.

This is probably the only group that can generate some "alpha" for the more knowledgeable/lucky reader. Especially with regard to the first 6 baby bonds. You should not be surprised to see that these companies are competing that can lose the most money in a single year and they are doing a really good job. As I promised earlier, I can recommend 2 authors on Seeking Alpha who do a very good job of finding the exact moment to buy these fairly toxic issues:

Richard Lejeune has developed his own rating system for high yielding income securities and even has an article on two of these baby bonds - RFTA and DSXN.

J Mintzmyer is an author I think anyone would recommend on shipping issues and I am no exception, so read what he has to say about SBNB, SSWN, DSXN, etc...

Now we'll discuss the least interesting group of them all...

  • Baby bonds with yield to maturity being yield to worst and very, very long life ahead (in investment years):

CTZ with its 6.59% yield and "just" 38 years to maturity is the rockstar in this group. Jokes aside, this is the market. You may want higher yield, but you will have to take more risk. Each of these securities should be viewed very carefully through the lens of interest rate risk. If yields rise you may have locked in a 6% yield for the next 30 years, but the value of your investment can decrease significantly through the years. Buying any longer-term fixed instrument is a bet on yields and if you don't take appropriate measures, you may end up like an oil company in 2016.

  • adjustable rate baby bonds

OSM, ISM and PFK will soon mature and there is almost no arbitrage left in them. TVE and TVC reset their rate based on the 30-year constant maturity rate and their high credit rating makes their yields really miserable. As for the fixed to floating baby bonds in the table, I suppose you can read one of my old articles.

  • The toxic ones. These are the most interesting baby bonds currently. Just three of them:

When you see yield to maturity of 25% as is the case with MFINL, you have to stop dreaming, unless you have done very detailed research on the company. I personally never buy and hold such instruments without the proper hedge, and when it comes to MFINL, I am absolutely clueless. The other two, SBLKL and SLTB, are shipping baby bonds of companies that posted very large negative results in the last year and continue to throw money in the ocean with every new delivery, but on the other hand you need the companies to just survive in order for you to gather those tasty 10%-plus yields. If it were a certain event there would be no opportunity.

  • The blue chip baby bonds. Issues over USD 250 mln that trade under par as a benchmark so we can determine where a long-term baby bond should be priced:

This chart is constructed from the biggest issues in the baby bond world and one can assume that they will be the most fairly priced ones. Indeed the lower the rating, the higher the long-term yield. If this chart is representative you would expect a long-term AA+ bond to be priced at 4.7%, A at 5.30%, BBB - 5.50%, BB+ and BBB - 5.90%, BB - 6.5%. This model is supposed to give a good idea of where new issues should trade. I have found a lot of undervalued IPOs through the years based on similar comparisons. These issues are extremely well correlated to the long-term yields. Here is proof:

There is a 2 standard deviations difference in holding the proposed portfolio of preferred stocks vs. TLT for the last 150 days. This is obvious proof that by holding these types of issues you are exposed to interest rate risk and have to act accordingly.

  • Perpetual debt securities with qualified dividends. The 4 outstanding ING debt securities - ISP, ISG, INZ, IND - are very similar to preferred stocks, being perpetual and paying qualified distributions. They are really strange, as most European financial securities are, but as long as they are not redeemed they are among the highest yielders with preferential tax treatment. Here you can see their yield metrics:

INZ is the first candidate to be redeemed and a lot of European income securities are being redeemed lately, so I personally do not find these securities attractive in any way. However, my knowledge is limited to just comparing the alternatives and the basic financial risk of redemption. If you have a solid idea of when these will be redeemed, you may end up gathering some qualified distributions.

Author's personal picks

  1. Low credit risk with possible leveraging. WSFSL (I find this to be the most interesting one at current price), CLA, MDLX, AFST, AFSS, OMAA, MCV, AGO-E (taking on call risk here)
  2. High credit risk compensated by short term to maturity. SBNB, SBLKL (only because of the sharp rally in the common stock which gives me a hedging reaction)
  3. High duration, extremely low credit risk. Any of the A or higher rated baby bonds from utility companies with interest rate risk hedge. The idea here is to leverage the income while borrowing at low rates. Be a bank.

Putting my proposed portfolio to interest rates sensitivity test. As most of the stocks don't have long historical data I will use just those that have, but the idea is obvious:

The correlation is high as all the stocks felt the shift in the yield curve. But if you remember the example above where for $20,000 you needed $14,000 TLT to hedge, here for a $23,000 portfolio, you need just $5,000 TLT to hedge. The current volatility in yields gives us a perfect opportunity to learn how to hedge our portfolios and how to switch to less sensitive instruments while still hunting for yield.

Author's note. All charts are from my personal databases and software. Yield to call calculations are made with adding 1 month to the call date for stocks already callable and adding 2 weeks for stocks that are callable in the future, because the most likely difference between payment date and call date is 2 weeks. This can become a monthly report and all suggestions are welcome.

Conclusion. Unfortunately, and as expected, there aren't any real bargains in the baby bond world. The large issues are rated, fairly priced and only small arbitrage opportunities arise from time to time as if just to attract some liquidity. Yields to worst above 6% on quality issues are still a rare find. The issues that present some good opportunities for the income investor are hard to trade and need further due diligence, because there aren't many analysts interested in tracking a 2-million-share issue. Some of the baby bonds have fallen by as many as 4-5 points, but from a relative point of view they are as expensive as they had been before yield started to raise. High yield is also not cheap and according to prices there is only one distressed issue in baby bonds - MFINL. It is a tough market to enter right now, but you can probably say that most of the time.

High quality means high duration, low yields. Low duration means questionable quality, low yields.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AFST, WSFSL, SBLKL, OMAA, AND ALL OTHER STOCKS MENTIONED over the next 72 hours.

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.

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