Baby Bonds offer 7% yields with investment-grade credit

Income investors hunting for yield are finding it in an obscure corner of the corporate bond market where well-known issuers are paying returns not seen in over a decade and a half.

"Given long maturities and limited liquidity on smaller-sized Baby Bonds, investors should evaluate the sector on a bond-by-bond basis," Frank Sileo, a senior fixed-income analyst at UBS, said.

Baby Bonds carry a $25 face value versus the standard $1,000 for corporate debt and trade on the NYSE or Nasdaq, providing transparency and liquidity that contrasts with the opaque over-the-counter bond market where most corporate bonds trade. Nearly $40 billion of Baby Bonds are outstanding. Yields offer a premium of about two percentage points above the 30-year Treasury, now around 5.25 percent, and exceed those on many preferred stock issues, including bank preferreds from JPMorgan that yield about 6.5 percent.

For income investors, the opportunity is significant: yields comparable to junk bonds but with investment-grade ratings from Moody's and S&P Global Ratings. Most Baby Bonds carry ratings of Baa from Moody's and Triple-B from S&P. But the long maturities, often stretching beyond 30 years, make Baby Bonds highly rate-sensitive, with prices on many issues down more than 10 percent this year as long rates have climbed.

Where the Yields Are

AT&T has a large $1.3 billion Baby Bond issue with a 5.3 percent annual interest rate due in 2066 that trades around $19.70 per bond and has a yield to maturity of 7 percent. The bond, ticker TBB, carries investment-grade ratings of Baa2 from Moody's and Triple-B from S&P, with average daily volume exceeding 100,000 bonds. It traded close to $24 a year ago, illustrating the downside when rates rise.

Ford Motor has three sizable Baby Bond issues outstanding, appealing due to yields above 7.5 percent. Ford's 6 percent issue due in 2059 (F.PRC) trades around $20 for a yield to maturity of about 7.7 percent. The Ford issue is split-rated, with an investment-grade BBB- from S&P and a junk rating of Ba1 from Moody's, but the company's financial outlook has improved.

Prudential Financial has three subordinated debt issues including a 5.625 percent bond due in 2056 (PRS) that trades below $21 for a yield of almost 7 percent. W.R. Berkley, a property and casualty insurer, has subordinated debt including a 4.125 percent issue due in 2061 (WRB.PRB) trading around $15 for a 7.25 percent yield. Utilities including Duke Energy and CMS Energy are among the largest Baby Bond issuers in the subordinated market, with deals yielding 6.75 percent to 7 percent.

The Risks to Weigh

A major risk is the long maturity dates that often stretch beyond 30 years, making Baby Bonds highly rate-sensitive. If long rates continue to increase as concerns about federal deficits and inflation grow, Baby Bond prices could fall further. But if long rates fall, prices could rally sharply. Most Baby Bonds trade well below their $25 face value, giving them appreciation potential if rates decline.

Baby Bonds are best suited to retirement accounts like IRAs and 401(k) plans because interest is subject to federal and state income-tax rates. This contrasts with preferred stocks, whose dividends generally are taxed at a 20 percent federal rate like common stocks.

One wrinkle: Baby Bonds usually can be redeemed by companies five years after issuance. This is normally a negative for investors because it limits upside for bond prices. But given the sharp rise in rates, most Baby Bonds trade well below $25, neutralizing the negative redemption feature.

Sileo cautioned that many senior debt Baby Bonds come from junk-grade companies offering higher yields but more risk. Lumen Technologies, for example, has 6.5 percent bonds due in 2051 (CTGG) that trade around $16.50 and yield about 10 percent, reflecting junk ratings from Moody's and S&P.

This article is for informational purposes only and does not constitute professional advice.