Special Report: Investing in "Baby Bonds"

Investors are constantly being told to have a mix of stocks and bonds.

Let's be honest though, stocks are easy to purchase and manage, while bonds most definitely are not.

Sure, you could go through a mutual fund or ETF, but they have their own issues.

Investor outflows can punish those who stay invested because it forces the fund to sell holdings at bad times — like during short-term price drops — potentially removing strong long-term holdings to raise enough cash.

You only have to look at the PIMCO fiasco for proof that external factors can come from nowhere. Bill Gross, once a paragon of bond investment, underperformed, then defected from PIMCO.

The amount of money lost by investors as a result totaled in the billions.

Then there are the other hurdles involved. A properly managed bond portfolio is constantly rotated and reinvested, creating a lot of work for a do-it-yourself approach.

Plus, government and corporate bonds come with a minimum $1,000 investment each, making diversification nearly impossible unless you have a five- or six-figure bond allocation.

Last but certainly not least, there are the fees involved. Fee disclosure for funds has gotten a lot of negative press and inquiries from Congress, and rightfully so.

Fund managers are skimming massive amounts of money off of retirement account balances and sabotaging account growth in the process.

Thankfully, there is a way to combine the convenience and low-cost of stock trading with the steady income investing that bonds provide.

We call them “baby bonds” because that is exactly how they behave. They can be bought for as little as $25 each, trade just like a stock with no fee after the brokerage order, and can provide steady income via high yields that cannot be gained elsewhere.

So what exactly are “baby bonds?”

They are a little-traded — at least by individual investors — type of equity called preferred stocks.

Preferred Shares vs. Common Shares and Bonds

Every stock or bond you can trade is a mechanism to raise capital by a company.

For regular stocks, it is as simple as selling a chunk of a company. More shares can be issued by companies to raise money and (hopefully) grow the business.

That is exactly why outstanding shares are considered liabilities on balance sheets. Companies sell them to you, moving funds into their “cash and equivalents” column.

This is offset by either diluting the value of all shares, or by removing shares owned by the company from its assets.

Bonds, unlike shares, are pure debt mechanisms. For $1,000 per bond, you are locked into an investment that provides regular interest payments and a return of the original amount (the principal) at the end of the bond term.

Between when the bond is issued and when the principal is repaid, bond values fluctuate purely based off of what bond traders are willing to pay for them.

For riskier debt, the bond price tends to go down because of a greater risk that the bond will default and money will not be returned. For safer debt, bonds often trade above the $1,000 face value.

Preferred shares of a company are a hybrid approach to raising money for a company. They are a form of fixed-term debt that trades like “normal” shares.

They start at $25 per unit and are offered through stock exchanges. The price of the shares will fluctuate based on what traders are willing to pay to collect income from them in the form of a dividend yield.

Compared to normal shares, the share price will rarely fluctuate as much and the dividend yields are significantly higher than common share yields.

Compared to bonds, they are easier to buy and sell, and are much less expensive per unit.

This is a simplistic view of what can be a fairly diverse class of shares, so we'll be better off if we discuss more details as we check out their pros and cons.

Pros and Cons

Let's run down the full list and go over anything that might need it:

Pros

  • Much less volatility than common shares
  • Higher yields than common shares
  • Senior claim to equity and assets
  • Lower price than bonds
  • Higher yields than bonds
  • Easier to buy and sell with low fees than bonds

Cons

  • Far less appreciation potential than common shares
  • Less consistent dividend/ interest payments
  • Normally can be reclaimed (called) at any time
  • Lesser claim to equity and assets than bonds
  • No shareholder voting rights
  • Nonuniform terms and conditions

Now let's move down those lists in greater detail.

First up, let's combine one pro and two cons: much lower volatility compared to common shares on the pro side, far less appreciation potential than common shares, and how preferred shares can be reclaimed by the issuing company on the con side.

A vast majority of preferred stocks come with the condition that the company has the right to buy out shareholders anytime after a fixed date.

As a result of this, buyers rarely want to pick up preferred shares at a price that is substantially more than the $25 face value that the company will pay to buy back shares.

This is especially true when broader interest rates are going down. If the company can keep preferred shares attractive to investors at a lower yield, they can simply call shares back, then issue a new batch with a lower yield.

No one would want to buy shares at $30 and take a 20% loss if and when the company decides to exercise its right to call shares back.

This means that share appreciation potential is low, but it also means that preferred share volatility is low too. The “callability” and open-ended nature for how long shares will remain outstanding guarantees $25 is returned per share, unless the company goes belly-up.

As a result of the lack of appreciation, companies normally have to offer higher dividend yields than common shares to entice investors. For investors seeking income, this is definitely a good thing.

The yields are higher than what you'd get from bonds because of callability, potentially less consistent payments, and a lower spot in the hierarchy of claims to assets and equities.

Bonds are above preferred shares, which are in turn above common shareholders, if the company is liquidated.

Then there is the issue of the potentially less consistent dividend payments.

A majority of preferred shares come with the condition that the company can, at its choosing, decide to withhold dividend payments to preferred share owners.

This normally comes with the condition that shareholder dividends accumulate. Essentially, the dividend that is not paid is rolled into the next dividend payment, assuming the company can pay it then.

This means that shareholders may miss a dividend, then make up for it next time around. However, companies with cash flow problems do not often fix the issue by the next quarter.

Once again, this puts preferred share owners between bondholders and common shareholders.

Bond owners are guaranteed interest payments unless the company defaults. Common shareholders can see dividends suspended indefinitely with no guarantees.

Preferred shareholders sit between, with no obligation from the company to consistently pay them, but with a rolling obligation from the company to eventually make up for missed payments.

Finally, there are the nonuniform terms and conditions of the preferred shares companies offer. They are not homogeneous. You will have to read the extremely dry and boring prospectus to make sure there are no surprises.

Final Notes

There are a couple other aspects of preferred stocks that could be good, bad or neutral, depending on what you're looking for in the investment.

Some can be converted into common shares. This will remove the cumulative dividend payment guarantee and other advantages, but will grant exposure to regular dividends (if they exist) and share appreciation.

Some have adjustable rates, making income from the investment variable. This is a fairly new and uncommon feature. Dividends for these preferred shares are benchmarked to yields on U.S. government bond issues, providing some limited protection against adverse interest rate movements.

As for which preferred shares are worth an investment, the Outsider Club's Jim Collins gives regular recommendations through his Portfolio Guru weekly newsletter, if you are interested in more information.

We will continue to cover these and other investment opportunities as we do our utmost to provide individual investors the information they need to level the playing field with large institutional firms.

Through our Outsider Club e-mail newsletter, you'll receive all of our research and analysis as soon as it is published, so stay tuned for more in the days to come.


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