Income 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.
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.
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.
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.)