High Yield, Lower Risk with Baby Bonds

Baby Bond Investments for IncomeIncome investors are always striving to find the best balance between yield and risk.  The low-interest rate environment of the past few years has forced many income investors to take on more risk than might be prudent moving forward.  There is a type of fixed-income investment that many investors may not be familiar with, but which currently looks attractive from a yield/risk perspective – baby bonds.

Baby bonds?

No, I’m not talking about those European savings bonds intended for parents wanting to start a nest egg for their children.  Nor do I mean the municipal baby bonds (which I may write about at a later time).  What I mean here by baby bonds are those small denomination ($25) debt notes that are issued by business development companies (BDCs) and can be bought and sold on the NYSE or NASDAQ exchanges.

BDCs are companies similar to venture capital and private equity firms that earn income by making loans to small and medium-sized businesses.  Unlike VC and private equity funds, however, BDCs are not closed-end funds, so any interested investor may purchase shares of a BDC company in the open market.  With a pass-through tax structure similar to a REIT or MLP, BDCs are required to payout at least 90 percent of taxable income to its shareholders to avoid having to pay a corporate income tax.  Thus BDCs, typically pay out large dividends (8%-12% yields) to shareholders.  One of the ways that BDCs raise capital for their operations is to sell baby bonds.

Less Risky Than Dividends

If BDCs pay out high dividends, why not just buy shares of the BDC and take advantage of some dividend and capital growth over time?  Well, for one thing, BDC share prices have a notorious history for volatility especially when the economy and markets are under stress.  Dividend payouts have not always been assured.  During the 2007-2009 financial crisis, the shares of BDCs got hammered due to excessive risk taking and the use of leverage.  Dividends were cut.  Today, many analysts believe the companies are in much better shape, but the risk of share price swings and dividend cuts are still very present.

A less risky investment for income investors would be to consider purchasing the baby bonds issued by a BDC.  Since these are senior notes, holders of these bonds must be paid their coupon before shareholders receive dividends.  Market prices for these bonds do not fluctuate nearly as much as stock prices, and BDC baby bonds currently still yield between 5% and 8%.  As some of you may have noticed, purchasing BDC baby bonds is somewhat similar to another one of my favorite investments, i.e, purchasing preferred shares of REITs.  Both types of instruments are callable, but unlike the preferred shares, a baby bond always has a maturity date, which limits interest-rate risk if you do have to sell the bonds early.

Outlook

As with any debt investment, an investor in baby bonds needs to consider credit risk.  BDCs have done well over the past couple years, but in November Fitch Ratings issued an outlook that is projecting a more challenging period for the industry in 2015.  Fitch notes that some BDCs are resorting to increasing leverage by using off-balance sheet financing.  The bottom line is that increased price volatility of BDC common shares can be expected, and current high-dividend payouts will be in danger of being cut if the economy and interest-rate environment change.  Bond investors, however, do not have to worry about this as long as the fundamentals of the individual company issuing the notes are solid enough to ensure continued payment of the debt.

Considerations

I believe these baby bonds are smart income investments if investors are willing to do their homework and invest with discipline.  BDC baby bonds should only form a part of a diversified bond portfolio, not the bulk of it.  I believe once purchased, baby bonds should be held to maturity to completely eliminate interest-rate risk.  Since they are callable securities, you should compute both the Yield-to-Call and the Yield-to-Maturity of potential investments to make sure you understand what you are getting.  As interest rates rise over the next few years, it is less likely that these bonds will be called early, but you never know.

One security that I like and that you might consider researching further is the 6.125% Senior Note from Main Street Capital Corp. maturing 4/1/2023.  This note trades under the ticker MSCA, and has a call date of 4/1/2018.  Yield-to-call is 5.99%, and yield-to-maturity is 6.06%.  S&P updated its ratings for BDCs two weeks ago and assigned Main Street Capital an Issuer Credit Rating of BBB/Stable.

 

(Disclosure: I own MSCA and intend to hold until the bonds are called or mature. Yields mentioned are current as of December 26, 2014.)

 

 

 

Step-up Bonds for Rising Rates

step-up income investmentsThe latest economic data point to an improving U.S. economy with interest rates more likely to rise in the future.  For investors who hold traditional bond investments, this scenario poses increased risk to the value of their income portfolios.  Is there a way to continue getting steady bond income without having to take the hit to the value of the bonds?  As readers of previous posts know, I am not a big fan of bond funds but much prefer direct ownership of bonds held to maturity, partly because it mitigates this interest rate risk.  I believe building a bond ladder (or a ladder of defined maturity funds as mentioned in an earlier post) is still the better way to go.  But if ladders are not an option for an investor, are there any other alternatives that make sense under these conditions?  One type of Investment worth exploring for your portfolio is the step-up bond.

Future Payments are Higher

A step-up bond has a coupon rate that is scheduled to increase (“step-up”) to a higher rate at least once during the life of the bond.  If the coupon payment is increased only once, the bond is called a “one-step” bond, and if the coupon is scheduled to increase more than once, it is called a “multi-step” bond.  Typically issued by Government Sponsored Enterprises (Fannie Mae, Sallie Mae, etc.) and major corporations, these bonds are callable (redeemable) by the issuer at some future date.  Although step-up bonds offer a lower initial coupon rate versus similar fixed-rate bonds, if the bond is never called, the total amount of interest paid over the life of the step-up bond will be greater than the interest paid by a conventional bond that is issued at the same time.  An investor in a step-up bond, therefore, sacrifices current income for potentially higher yield over the life of the bond.

The Positives and Negatives of Step-ups

Besides lessening interest rate risk, the advantages of these bonds are that they are issued by high-quality institutions and they can be traded in a fairly liquid secondary market in case you want to sell them prior to maturity.   The higher future income is ideal for those whose needs for investment income may be more important down the road.  The big downside to a step-up bond, of course, is that the issuer can force you to redeem the bond early by calling it.  This will happen if the coupon rises above market rates, thus forcing you to reinvest at a lower yield.  You might be able to buy a non-callable type of step-up bond (canary call) to avoid this, but these are not as common.  Although the coupon rates on non-callable bonds might be lower than for the callable bonds, you can count on getting the higher yields later.

Considerations for Income Investors

Since interest rates are likely to rise in the future, it is less likely that recently issued step-up bonds will be called. Buying and holding step-up bonds until maturity seems like a reasonable option at this time.  A couple of things to keep in mind as you investigate further:  1) the higher the coupon rate and the closer it is to the maturity date, the more likely it is that a step-up bond will be called, and 2) most step-up bonds pay interest only every six months, so if you want income quarterly or monthly, you might want to consider other alternatives.

 

 

 

Preview: The New Treasury Floating-Rate Note

floating-rate investment incomeFor bond investors who are  interested in variable-rate investments that increase interest payments as general interest rates rise, things should be getting a lot more interesting in the next few months.  The U.S. Treasury is scheduled to announce this month (November) the size of its initial January 2014 offering of new Floating-Rate Notes (FRNs). 

Overview

According to the Federal Register, the Treasury will be able to issue FRNs with maturities between one year and ten years.  The interest rate on these notes would effectively reset weekly based on the results from the weekly auction of 13-week Treasury bills.  The actual interest rates would be equal to the 13-week T-bill rate plus some “spread” amount.  Interest would accrue daily and be payable quarterly.  The Treasury is expected to issue no more than four FRNs per year.

Initial Offering

The initial January offering is expected to consist of $10-$15 billion of notes with 2-year maturities.  One of the key advantages of these notes is that they will have a minimum net yield of 0%.  This means that even if the Treasury allows T-bill auctions to result in negative interest rates, these notes will never be priced to reflect negative interest rates.  Individuals may purchase these notes through Treasury Direct with a $100 minimum. 

Outlook

I am expecting these notes to be very popular, especially if interest rates drift higher.  Banks (including foreign central banks) and corporate cash investors will be the dominant buyers, but individuals seeking a safe alternative to commercial floating-rate notes will also be buying.  Holding these notes will be a popular alternative to rolling T-bills, which may incur significant transaction costs.  The high demand for these notes will likely lead to relatively low yields (probably just slightly higher than the T-bills).  Like other safe, but lower-yielding products, these notes will be excellent vehicles in which to park cash or to use to ensure preservation of capital in a rising-rate environment.  Unfortunately, at least initially, the rates will still be too low to be attractive to most income investors.  When interest rates are a little higher, and the Treasury offers longer maturity floating-rate securities, those will most certainly be smart investments for income.

Smarter Bond Investing With Defined Maturity Funds

Defined-maturity fundsTwo popular ways to hold bonds in a portfolio are 1) to hold a collection of individual bonds or 2) to own shares of one or more bond funds. There are advantages and disadvantages to both approaches. Holding individual bonds guarantees return of your principal when a bond matures (assuming no defaults), but also requires a large amount to invest if you are to adequately “ladder” a portfolio to mitigate interest rate risks. If you have smaller amounts to invest, you can achieve better diversification with traditional bond funds or ETFs, but there is no guarantee that your initial investments will be returned at any time.

Defined Maturity Funds Make It Easier

Over the last year or so, new bond investment products have become available which combine the advantages of individual bonds with the advantages of funds. These so-called Defined Maturity Funds (mutual funds and ETFs) allow income investors to structure an income ladder that reduces interest rate risks while not requiring balances as large as would be required for individual bonds. Defined maturity fund products are currently available from Fidelity, iShares, and Guggenheim.

To explore more about these products and what can be done with them, check out these articles:
Build a Bond Ladder
Defined Maturity Fund Basics
Pros and Cons

Are Floating-Rate Funds Too Risky?

floating-rate fundsFloating-rate funds provide higher yield income to investors by buying bank loans made to companies with low credit quality. I like to think of these bank notes as intermediate-term junk securities (loan maturities are about seven years). Yields are higher because of the greater credit risk, but the banks consider the risk of loss somewhat limited because they have priority over other bondholders in the event of default. The securities are “floating-rate” because the bank loans are variable-rate loans. Since fund yields rise as interest rates rise, many investors see these floating-rate funds as attractive income investments that can hedge against inflation.

But are there other risks that investors should be aware of? In July 2011, the Financial Industry Regulatory Authority (FINRA) issued an investor alert warning on floating-rate funds. Here are some things you need to be aware of if you are considering investing in these funds:

– Bank loans are traded over the counter, not on an exchange. Thus, they are less liquid than investment grade bonds, and determining appropriate valuations for individual loans is difficult.

– Many floating-rate funds limit your ability to withdraw your money. Minimum holding periods and redemption fees are common.

– Many floating-rate funds have high expense ratios.

– Some floating-rate funds are leveraged (i.e., they borrow money to purchase additional loans to get higher returns). For these funds, the consequences of loan defaults could be more severe since the cost of buying on margin has to be factored in.

In one of his articles (here), Larry Swedroe makes the case that floating-rate funds really have equity-like risks and behave more like stocks than Treasury bonds.

At the present time, I don’t like these funds for all of the reasons given above, and because it is still likely that low interest rates may persist for a while longer (remember that in August 2011 Bernanke promised low interest rates through mid-2013). In the future, after an inflation trend has been established, I may take another look at them, but right now, I still see significant downside risk to owning these funds. In my book, they are not smart investments for income.

TIPS: Negative Yield vs. Inflation Hedge

TIPS bond incomeYields on 10–year Treasury Inflation-Protected Securities (TIPS) are at record lows. As of this writing (July 2012), the 10-year TIPS have a negative yield of -0.637%. This indicates that investors believe so strongly in future inflation that they are willing to bid up prices of the security to the point of negative returns. It’s important to understand that in practice, when you purchase a TIPS with a negative yield, you don’t have to actually make interest payments back to the Treasury. The Treasury will payout interest to you at 0.125%, but an appropriate premium is added to the price you pay for the security so that the stream of interest payments minus the premium is equivalent to the negative yield. Some analysts believe it makes no sense at all to buy securities with negative yields. Others, however, say that you should consider current economic conditions and prospects to determine if buying negative-yield TIPS might make sense.

The Math

Let’s look at the arithmetic. The current 10-yr Treasury yield is 1.43%. Buyers of the 10-yr TIPS are therefore betting that inflation over the next ten years will average at least 2.067% (Treasury yield minus TIPS yield). That seems like a very reasonable assumption to me. Under this scenario, the TIPS investors believe that the TIPS inflation adjustments will increase the principal of their holdings at a rate that will more than make up for the initial price premium they paid for the security. The greater the inflation rate is over the period, the greater their return. Theoretically, this all sounds okay to me. In practice, I do have a couple of concerns.

Concerns

One of my concerns is the inflation scenario. Let’s say I buy a 10-year TIPS today (holding it in a tax-favored account of course). Suppose due to political and other factors, the Fed undertakes no further quantitative easing, and the economy stagnates. Over the next 5 years the inflation rate is -1.0% (deflation). Then a new political order takes power, circumstances change, and the Fed goes forth with quantitative easing resulting in inflation of greater than 4% annually over the final 3 years prior to my TIPS maturing. If, averaged over the 10-year period, the annual inflation rate turns out to be 2.2%, would that mean I made money on this investment? Not necessarily. I haven’t run the numbers, but I don’t think it would be too hard to come up with a scenario where an initial deflationary period reduces the adjusted principal (and, thus, the associated interest payments) to the point where later inflation adjustments on the smaller adjusted principal balance don’t make up for the earlier losses. I would get my principal back at maturity, but the total interest payments that I received might not be enough to offset the initial price premium I paid when I purchased the security.

A more fundamental concern I have is with the basis of the inflation adjustment. TIPS adjustments are based on CPI-U. Because of the way that statistic is calculated, there is a 2-month lag in the adjustment. Again, if significant inflation occurs during the final months prior to maturity, the lag in adjustments means there may be a couple months of inflation that are unaccounted for at maturity. Also, as a government statistic, CPI-U can always be manipulated and redefined for political reasons.

Bottom Line

So do I invest in TIPS now? For me personally, the answer is no. I will wait until the yield on 10-year TIPS turns positive, i.e. at least 1.5%. After all, I am primarily interested in investments for income, not just capital
preservation. If I can get at least 1.5% yield, and the 10-year Treasury yield remains below 4.0%, I’m in.