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.)

 

 

 

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.