Baby Bonds Complete Review

Oct. 23, 2019 1:54 PM ETAFH, AFHBL, AAIC, AQNA, AQNB, CNFR, CNFRL, LRFC, CTY, F, GECC, GECCL, GECCM, GECCN, INBKL, INBKZ, INSW.PA, LMHA, LTS, PFX, MDLQ, MDLX, MDLY, MHLA, MHLD, MHNC, PBB, PBI, PBY, PFF, PGX, QVCD, TA, TDE10 Comments15 Likes

Summary

  • A review of all baby bonds.
  • All the baby bonds sorted in categories.
  • What has changed during the past month?
  • I do much more than just articles at Trade With Beta: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

In this article, I'll review all the baby bonds, listed on a national exchange, sorted into several categories. There are 188 issues in our database that trade on primary exchanges. Since there is no common ETF for baby bonds only, I'll examine the two largest primary exchange-traded fixed-income ETFs with a market capitalization of over $22.4B in general, the iShares U.S. Preferred Stock ETF (PFF) and the Invesco Preferred Portfolio ETF (PGX). As we can see in the charts below, 68% of PFF's holdings are preferred stocks, which occupy 65% of the market capitalization of the fund and also 69% of PGX's holdings are preferred stocks with a market capitalization of 73%. Still, with more than $4.8B in baby bonds, in general, these two are the most representative for this kind of fixed income securities.

PFF

Source: Author's spreadsheet

PGX

Source: Author's spreadsheet

Now that these products have our attention, we are continuously monitoring all baby bonds by several groups and will reinstate our monthly review, publishing a recap of the groups of interest. First, let's take a look at the main indicators that we follow and their behavior during the last month.

TNX - CBOE 10-Year Treasury Note Yield Index ($TNX)

Source: Tradingview.com

iShares U.S. Preferred Stock ETF

Source: Tradingview.com

Invesco Preferred Portfolio ETF

Source: Tradingview.com

SPDR S&P 500 Trust ETF (SPY)

Source: Tradingview.com

The most significant indicator for all fixed-income investors, the 10-year Treasury Note Yield (TNX), has again bounced back at the current rate of 1.75% after it had previously fallen again close to its over 3-year low at a rate of 1.50% in the first week of October. And this comes against the background of the Federal Reserve's decision to lower borrowing costs for the second time this year and signaling that a further interest cut before the end of the year could come. Furthermore, the Federal Reserve is extending its repo operations at least through January of the next year. Despite the fact that the FOMC directs the Desk to purchase Treasury bills at least into the second quarter of 2020 to maintain ample reserve balances over time at or above the level that prevailed in early September 2019, the treasuries turned bearish, basically as a risk-on with the most recent US-China trade deal developments. The fixed-income securities have consolidated, and neglecting the unstable behavior of the bonds and common stocks markets, managed to stay calm, with PFF and PGX trading at their 2-year high.

As for the equity markets, the S&P 500 has been all over the place with a series of mixed news, including: the disappointing ISM U.S. manufacturing index that showed its lowest level in more than 10 years; the jumped expectations for an October rate cut to 93.5% from 77%; the unemployment that hit a new 50-year low, at a rate of 3.5% - a level unseen since December 1969; and the main market mover, the reaching of a substantial phase one deal between the U.S. and China.

The Review

These baby bonds resemble the preferred stock securities in their basic features. They are debt securities that are generally issued in $25 denominations and have maturity dates of 5 to 84 years (in our database, AGO-F is the security with the longest maturity, 7/15/2103). Baby bonds are normally redeemable at the issuer's option on or after five years from the date of issue at par. Most of these debt securities pay quarterly interest distributions. In payment of interest and upon liquidation, the exchange-traded debt securities rank junior to the company's secured debt, equal to other unsecured debt, and senior to the company's preferred and common stock. An important note is that all baby bonds are not eligible for the 15% tax rate on dividends as there are U.S. securities that pay interest, not dividends.

1. Call Risk Baby Bonds YTC < 0

The lower the bond, the higher the risk. Be careful not to get surprised in these ones if you are tempted by the higher yield. In simple terms, these securities are trading above their par value and can be subject to redemption at any time. The immediate capital loss leads to negative returns.

Currently, a total of 51 of all baby bonds that are listed on a National Exchange bear a negative Yield-to-Call. In other words, 27% of this type of fixed-income securities carry a call risk. Even, we already see an issue like LMHA, callable after year and a half that carries a call risk (although yielding at the negligible -0.05% to its call date).

1.1 Long Time No Call

Source: Author's database

1.2 Short Time No Call

Source: Author's database

2. Baby bonds below PAR, YTM < 10%, yield curve:

Source: Author's database

The rated ones only:

Source: Author's database

Here is the full list:

Source: Author's database

With the securities in the next paragraph, we have an aggregate of only 23 baby bonds trading below their par value or in other words 12% from the whole majority. As you can see, only 5 are rated from the S&P, 3 of which are investment-grade "babies" that are trading at a price lower than $25. As for the rest, the main reason to trade below PAR is the increased credit risk for its holders. Medley Capital (MCC), Maiden Holdings (MHLD), Pitney Bowes (PBI), Ladenburg Thalmann Financial Services (LTS), Conifer Holdings (CNFR), Capitala Finance (CPTA), TravelCenters of America (TA), and Arlington Asset Investment (AI) have charts of their common stock which unfortunately do not show much confidence for their creditors.

3. Baby bonds YTM > 10%. Be careful with these babies:

Source: Author's database

This is the most speculative group of baby bonds. However, it also has been reduced over the past few months to only 3 securities.

Despite the huge drop in the price of Maiden Holdings that is trading at only $0.63 and is facing a serious risk of bankruptcy, MHNC that is currently at a YTM of 9.35% and MHLA with its YTM of 9.85% are now one step up, which, however, is not necessarily defined as increased safety.

The Medley (MDLY) "babies", MDLQ and MDLX, continue to take part in this group due to concerns about the upcoming merger of Medley Capital, MDLY, and Sierra Income Corp.

As for CNFRL, it takes part in this group due to the common stock CNFR's poor performance and mainly because of the low liquidity of the bond.

Take a look at the full list:

Source: Author's database

4. Baby bonds > Par, yield curve by Yield-to-Worst and Years-to-Call:

Source: Author's database

Now, only the rated ones. For a better idea, I've excluded the Telephone and Data Systems' senior notes (TDE), which is the only callable one, for us to have a clearer look over the yield curve.

Source: Author's database

The next step is to exclude the non-investment grade ones and to observe the yield curve of all investment-grade baby bonds:

Source: Author's database

The two investment-grade baby bonds with the highest Yield-to-Worst currently are the Qwest Corporation's CTBB and CTDD with YTC of 6.55% and 5.93%, respectively. QVC's QVCD that was the last month's highest YTW baby bond is now yielding at 5.08% (a 1.09% lower YTC). All securities fall below the 5% threshold as even Ford's (F) F-B that had fallen due to the Moody's downgrade of Ford's senior unsecured debt (including F-B), from investment to below-investment rating, is now trading at a YTC of 4.74% (a 1.23% lower from the last month). Still, at this point, such a downgrade does not happen from Standard & Poor's and F-B is currently rated a "BBB". An interesting fact is the highest non-investment grade baby bond, the BB+ rated SJIJ is trading at a Yield-to-Worst of 4.92%. INSW.PA that carries a "CCC+" rating has a Yield-to-Call (its YTW) of only 3.19%!

5. Fixed-to-Floatings:

  • By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

Since after the call date, they all change their nominal yield, this chart may be misleading. That's why the best way to compare the group is by their Yield-to-Worst (equal to their Yield-to-Call). This is a much more plausible yield curve.

  • By Years-to-Call and Yield-to-Call:

Source: Author's database

  • The Full List

Source: Author's database

INBKZ and INBKL are located at the top of the chart, meaning it has the best Yield-to-Worst from the group. However, they are the only ones that are not rated by S&P. Except for AQNA and AQNB, the rest of the baby bonds carry an investment-grade rating.

6. Baby Bonds issued by a BDC

Under the 1940 Act, BDCs must generally meet certain levels of asset coverage with respect to their outstanding "senior securities," which typically consist of outstanding borrowings under credit facilities and other debt instruments, including publicly and privately offered notes. "Asset coverage," as defined under the 1940 Act, generally refers to the ratio of a BDC's total assets compared to its aggregate amount of outstanding senior securities, which allow BDCs to decrease their asset coverage requirement to 150% from 200% under certain circumstances.

  • By Years-to-Maturity and Yield-to-Maturity:

Source: Author's database

  • By Years-to-Call and Yield-to-Call

For this chart, I'll leave only those securities that are not callable yet, trade above par, and have a positive YTC. Let's examine the yield curve of all BDCs' baby bonds.

Source: Author's database

Take note that except for PBB and PBY ("BBB-" by S&P), all other securities are not rated by any of the big three rating agencies.

7. Ex-Dividend Dates:

Which baby bonds are ex-dividend for the next 45 days? The date given is predicted on the base of the previous ones and may vary by a few days.

Source: Author's database

The ex-dividend dates are very useful for every fixed income investor who practices the dividend capture strategy.

8. A Look at the Most Recent Redemptions

There are 4 securities called for the past three months:

Source: Author's database

Here is the full list:

Source: Author's database

In addition, there is one issue that was delisted from The Nasdaq Global Market on October 17, 2019, OTCPK:AFHBL, due to AFH's continuation non-compliance with Nasdaq's filing requirements.

Source: Author's spreadsheet

9. A Look at the Most Recent IPO:

There are 8 baby bonds, issued for the last month.

Source: Author's database

To the issues in the chart above, there is 1 that has to be added to this list, but still do not have permanent ticker and is currently trading over-the-counter: AEGON Funding Company LLC 5.10% Subordinated Notes due 2049:

Source: Author's spreadsheet

10. How do they move?

Here is the general idea of how the baby bonds have moved since the start of the month:

Source: Author's database

MDLQ and MDLX continue their climbing with another $2 gain for the period of the last 30 days, being the while CNFRL is located on the opposite shore with a loss of $2. For a clearer view, I will exclude the three securities from the following charts.

  • Top Gainers:

Source: Author's database

  • Top Losers:

Source: Author's database

Conclusion

This is what our small world of baby bonds looks like at the second half of October. Although at a slow pace, the New Year's rally for all fixed-income securities never stopped, as the situation is not much different from the previous month. Yields are falling with each month, and there has been almost no correction since December last year, except for a few days through which there was a more tangible selling. However, this was quickly stopped and didn't take long for all to get back on the path of buying. With only 23 baby bonds (from a total of 188) that are trading below their par value, it becomes harder and harder to find good returns from a bond that does not trade at a significant premium. Just take a look at LMHA, a year and a half until its call date and already trading at a negative YTC. From the bonds below PAR, except for the GECC's notes, CTY, and BSA, to take advantage of the other's yields, we have to make a compromise on credit risk.

At this point, on a comparative basis, as decent issues without taking too much credit risk, I find GECC's baby bonds - GECCM, GECCL, and GECCN. The company's debt-to-equity and interest coverage ratios are good. Moreover, it's a BDC that needs coverage of at least 150% of gross assets less all liabilities and indebtedness not represented by senior securities, after each issuance of senior securities. The three are yielding at an average of 6.56% Yield-to-Call, a return that is hard to find from issues trading at or above par value. As the most conservative option in terms of safety, I believe to be GECCL, having 6.74% YTM for 3 years to maturity with no call risk. As another good value, I find CTBB that is the highest YTW rated baby bond, being an investment-graded, giving a YTC of 6.55%, while almost all others are placed below the 5% barrier. This may generally apply to CTDD that is yielding at a rate of 5.93%.

Note: This article was originally published for our subscribers on 10/20/2019 and some figures and charts may not be entirely up to date.

Trade With Beta

The Trade With Beta team has been submerged in the universe of preferred stocks and baby bonds for almost a decade, and we decided to share our knowledge and expertise through the inception of this service. We attempt to cover all aspects of these products, from IPOs to pair trades and portfolio picks and, last but not least, issues. Additionally, once a month, we go through all different groups of fixed-income instruments to make sure that nothing has gone unnoticed.

This article was written by

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Day trader whose strategy is based on arbitrages in preferred stocks and closed-end funds. I have been trading the markets since I started my education in Finance. My professional trading career started right before the big financial crisis of 2008-2009 and I clearly understand what are the risks the average investor faces. Being a very competitive trader I have always worked hard on improving my research and knowledge. All my bets are heavily leveraged(up to 25 times) so there is very little room for mistakes. Through the years my approach has been constantly changing. I started as a pure day trader. Later I added pair trades. At the moment most of my profits come from leveraging my fixed income picks. I find myself somewhere in between a trader and an investor. I am always invested in the markets but constantly replace my normally valued constituents with undervalued ones. This approach is similar to rebalancing your portfolio and I just do this any time there is some better value in the markets. I separate my trading results from my trading/investment results. I target 40% ROE on my investment account and since inception in 2015, I am very close to this target.


My main activity is running a group of traders. Currently, I have around 40 traders on my team. We share our research and make sure not to miss anything. If there is something going on in the markets it is impossible not to participate somehow. Some of my traders are involved in writing the articles in SA. As such Ilia Iliev is writing all fixed-income IPO articles. This is part of their development as successful traders.


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*If it is on the exchange it is overvalued and our job is to find the least overvalued.

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*High yield is always too expensive.


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