Who can resist a baby? A cute newborn could make even the grumpiest person go “ooh” and “aah.”
Likewise, in recent years investors have cuddled up to a type of security called a “baby bond.” But it’s important to note that while a real baby is generally harmless (unless you count sleep deprivation as harm), baby bonds carry a number of risks.
Like other types of bonds, baby bonds are debt instruments that trade on exchanges, like stocks. These notes are sold in small increments of $25, far less than the $1,000 face value of traditional corporate bonds — hence the nickname baby bonds.
Issuers of baby bonds include utility companies, investment banks, telecom companies and other types of corporate issuers, and business development companies (BDCs) — investment companies that fund small and mid-sized businesses.
The coupon rates offered by baby bonds are generally fixed and are relatively high, ranging from around 5 percent to 8 percent. Interest payments are typically made on a quarterly basis. Like other types of bonds, maturity dates vary, but are often in the 10-year to-30 year range.
If you’re thinking about purchasing baby bonds, you should understand both their features and their risks before you determine whether a baby bond is the right investment for you given your personal goals and risk tolerance.
“Baby bonds aren’t easy to recognize. Because they trade on exchanges and offer coupon payments, baby bonds tend to look like high-yielding stocks. In reality, these securities are actually debt instruments with complex features,” noted Sara Grohl, director, emerging regulatory issues, at the Financial Industry Regulatory Authority (FINRA).
Here are some things you need to know before you pick up baby bonds.
Baby Bonds Are Often Callable
Baby bonds are typically callable meaning the issuer has the option to return the bond’s principal to you and stop paying interest before your note matures. The call dates for baby bonds tend to range from five to ten years from the time they’re issued.
Why should you care? If your bond is callable, but you don’t understand the terms, you could be caught off guard, and end up with a lower return on your investment than you were expecting.
And you’ll face reinvestment risk. Often bonds are called if interest rates drop because the issuer can refinance at a lower rate. While that’s great for the issuer, that means you could be stuck needing to reinvest the proceeds from the called bond at a lower rate of return.
Consider Liquidity Risk
What would happen if you bought your baby bond and then decided to sell it before it matures? Trading volume for baby bonds is generally thin, so the bid-ask spread — the difference between the asking price and the offering bid — may be wider compared to more heavily traded securities. That means it may not be so easy for you to find a buyer willing to pay you the price you want.
“FINRA is concerned that retail investors may not understand the liquidity risks they assume when gaining exposure to business development companies (BDCs) through baby bonds,” FINRA wrote in its 2014 Regulatory and Examination Priorities Letter. “The secondary market for these instruments is thin and investors forced to sell prior to maturity may be harmed.”
In The Event Of A Default, You Could Be Out Of Luck
Most baby bonds are classified as unsecured debt of the issuer, meaning they’re not backed by any underlying assets. If an issuer were to default, baby bondholders would get paid only after the claims of secured debt holders were met.
However, as with other debt instruments, baby bonds are senior to a company’s preferred shares and common stock.
Do Your Due Diligence
Some baby bonds may have below investment grade credit ratings. It’s important to read the prospectus of any baby bond issue and to check out the bond’s rating. That means the risk of default is considered higher than the risk for investment grade companies.
“If you aren’t comfortable investing in a high yield bond fund, you probably wouldn’t be comfortable investing in baby bonds,” noted Matthew McDonald, director, emerging regulatory issues at FINRA.
Be Aware Of Interest Rate Risk
Like other types of bonds, baby bonds face interest rate risk, meaning changes in interest rates may reduce the market value of a debt instrument that you hold.
When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. If rates were to rise significantly in the coming years, the market value of your baby bond could fall dramatically. Additionally, because baby bonds are traded on stock exchanges, prices of these securities may be vulnerable (or may fluctuate) in conjunction with overall stock market volatility.
That doesn’t matter if you plan to hold the baby bond to maturity, but it’s an important factor if you are hoping to trade that bond later. And if that’s the case, your baby might not be looking so cute for long.