What exactly are baby bonds? Most issuances of regular bonds only permit investors to buy them in $10,000 increments. Regular bonds are also a little more difficult to purchase through your broker and usually aren’t very liquid.
The difference with baby bonds is that they trade on the stock exchanges, just like stocks. In fact, that’s why they are called “exchange traded debt.” They are much more liquid and therefore easier to trade.
They are also similar to preferred stock, in that they are issued at par price of $25 per share. Regular bonds are issued $100 as par. However, there are a couple of other advantages to baby bonds. As you know, most bonds trade at the top of the capital stack. Right after them come baby bonds, which means they are actually placed higher than preferred stock.
What that means is that if the company should go bankrupt, bondholders get first bite at the apple, but baby bondholders get second bite. The good news is that baby bonds have, in my opinion, the same theoretical risk as most regular bonds do, yet they pay significantly higher interest rates.
Here are three baby bonds to consider.
Stanley Black & Decker, Inc. 5.75% Junior Subordinated Debenture (SWJ)
The legendary tool company Stanley Black & Decker, Inc. (NYSE: SWK) surprised me in that I wouldn’t expect a well-known company like this to issue baby bonds. Not that there’s anything wrong with baby bonds and well-known companies; it’s just that most companies with this kind of brand name generally stick to regular bond issuances.
Nevertheless the company has Stanley Black & Decker, Inc. 5.75% Junior Subordinated Debenture (NYSE:SWJ). This is really just a fancy way of saying it’s lower in the capital stack under all the other types of bonds that the company holds. The issue currently trades at $25.16, so it’s just a tiny bit above par.
Baby bonds get rated just like regular bonds due by the rating agencies. S&P has rated these particular bonds at “BBB+,” which is defined as them having “slightly more than adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to weaken the obligor’s capacity to meet its financial commitments on the obligation.”
Entergy New Orleans, LLC First Mortgage Bonds, 5.50% Series (ENO)
I came across another interesting issue with Entergy New Orleans, LLC First Mortgage Bonds, 5.50% Series (NYSE:ENO). The underlying company is an electric utility that sells electric power in four states and also includes the city of New Orleans.
One of the great things about utilities is that they have regional monopolies. Therefore, they have rates that are regulated. That means that the company knows, or at least can estimate, how much revenue it’s going to generate in any given year. Then it can target expenses and capital expenditures to such a place where it can forecast both profit and cash flow.
In the case of Entergy Corporation (NYSE:ETR), the common stock actually pays a 4.44% yield. Yet you can go higher in the capital stack and enjoy some potential capital gains while earning 5.5%. Plus, because these are first mortgage bonds, should the company go under, these bonds get first crack at the property that Entergy actually holds.
Verizon Communications Inc. 5.90% Notes (VZA)
With all the excitement going on in telecom right now, it’s worth having a look at the Verizon Communications Inc. 5.90% Notes (NYSE:VZA).
Verizon is a terrific company, one that has managed to stay afloat in an era where telecoms have become commoditized. In fact it’s done more than just stay afloat. It routinely generates very strong cash flow. That’s how it’s been able to keep paying its 4.58% dividend.
However, a very interesting thing is going on with the underlying company stock. Verizon Communications Inc. (NYSE: VZ) is trading at $47.75. That’s actually 10% below the price it was at exactly five years ago.
So if you been holding Verizon stock all this time you’ve actually lost 10%, while collecting the 4.58% dividend. You would’ve done better having held VZA and earning 5.9%
One other thing about baby bonds you should know. Unlike preferred stock, which treats distributions as dividends, and sometimes even as tax-free return of capital, baby bond distributions are classified as interest income.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance, and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at [email protected].