SAT - Baby Bonds: If You Liked Them In 2021 You'll Love Them Now At 8%+ Yields

2023-06-15 11:16:54 ET

Summary

• Baby bonds remain attractive options in income portfolios.
• We take a look at the investment case and highlight a pitfall in calculating baby bond yields.
• We close with a number of ideas.

This article was first released to Systematic Income subscribers and free trials on June 7.

Baby bonds remain core parts of many income portfolios due to their attractive combination of yield, resilience, decent quality and various duration options. In this article we review the investment case for baby bonds and take a look at a handful of ideas.

For investors unfamiliar with them, baby bonds are simply exchange-traded debt obligations. They are typically unsecured but can also be subordinated debt. They are called "baby" bonds because their denominations of, typically $25, are well below the standard $1,000 par amount for OTC corporate bonds. They are also traded on the exchange which makes execution much easier.

The Case For Baby Bonds In Income Portfolios

In this section we highlight the key features of baby bonds which makes them attractive additions in income portfolios.

First, their yields are very attractive with many decent-quality bonds trading at high single-digit yields. Today's yields are not far off the levels we saw during the COVID crash and are 2-3x higher of what they were in 2021.

Two, with Treasury yields at elevated levels, the possibility of future capital gains is real. The chart below shows that the price of the average baby bond fell to around $23 from its $26 level. Although we don't expect Treasury yields to retrace their 2021 lows, a modest fall is certainly possible. If that happens, it would support prices of bonds. Floating-rate instruments like bank loans wouldn't benefit from this dynamic.

Three, if we disaggregate the yield of high-yield corporate bonds into their Treasury yield and credit spread components we see that credit spreads make up about half of the total yield. This is relatively low relative to history where it made up most of the yield of high-yield corporate bonds. This development is due to both relatively elevated Treasury yields and relatively modest credit spreads.

In our view, this supports the case for holding securities that both monetize the relatively high level of Treasury yields and don't take full-blown exposure to credit risk. Many baby bonds fit the bill here.

Finally, many baby bonds are very resilient securities, particularly when compared to the common shares or preferreds of the same issuer. For instance, looking at an issuer of one of our baby bond positions, the BDC Oxford Square Capital Corp. ( OXSQ ), its common shares are down about 30% since the start of 2022 (down 13.4% in total return terms) while the median company baby bond is down about 7% (and is up in total return terms over the same period).

Avoiding The Yield Pitfalls

One of the main confusions regarding baby bonds has to do with the price and its relationship to yield. Investors who are starting out with bonds will ordinarily assume that a bond’s yield is just the annualized dividend divided by price which is what it is for stocks.

After a while, investors start to understand that unlike stocks, bonds (hopefully) mature at a certain price on a certain date (let’s put embedded calls to the side for the moment). This means that in addition to the coupon we need to take into account the pull-to-par i.e. the move in the price from whatever it is today to par at maturity.

This is well and good however a second complication is that we can’t use the bond’s market price in our calculation because exchange-traded bonds trade dirty i.e. with the accrued dividend in the price. In other words, a 6% bond trading at $24 could have up to $0.375 of accrued dividend in its price. In order to get the right yield we need to strip it out and come out with a stripped price (also called clean price) since what is going to pull-to-par is not $24 but anything from $23.625 to $24 depending on the number of days since the start of the quarterly accrual period.

These things are much simpler in the institutional / OTC bond world where bonds are quoted with a stripped price. However, the side effect of this and why this would never fly in the retail world is that the buyer has to pay the accrued to the seller above and beyond the agreed bond price.

Imagine retail investors buying a bond at a given price and the broker then demanding another $100 for the accrued - there is going to be lots of confusion. The way it works instead is that the $100 of accrued is baked into the bond price you see on the screen which solves one problem (the seller doesn’t ask for accrued separately) but creates another (less visibility on the stripped price).

At some point all of this becomes second nature to investors however it can take some time to develop the muscle memory to deal with bond yields.

Some Ideas

In our allocation to baby bonds (or to other security types, for that matter), we always think of a two-dimensional interest rate / credit risk spectrum. The idea here is to ensure that we both diversify across different levels of rate and credit risk as well as ensure that our overall allocation is appropriate for the given environment (i.e. lower credit risk when credit spreads are low and vice-versa).

As suggested above, we consider the current market environment as not particularly appealing from a credit risk perspective so we have tended to stick to decent-quality bonds. On the other hand, we see value allocating across the duration spectrum to both shorter-maturity and longer-maturity bonds.

Shorter-maturity bonds can act like "drier-powder" securities while longer-maturity bonds can generate potential capital gains if Treasury yields do move lower over time.

There are three sectors that we find particularly compelling in the baby bond space: CEFs, BDCs and mortgage REITs. These are not investment companies, rather than "normal" companies. The advantage of bonds issued by investment companies is that their behavior is much easier to understand and predict depending on various market scenarios. These issuers also provide instant diversification as each one of them holds many different securities in their portfolios.

Within that baby bond sub-space we continue to like the following bonds.

On the medium / longer duration side we favor:

• CEF OXLC 6.75% 2031 bond ( OXLCL ), trading at a 8.7% yield-to-worst
• BDC SAR 8.125% 2027 bond ( SAY ), trading at a 8.7% yield-to-worst

On the shorter maturity side we favor:

• mREIT AAIC 6.75% 2025 bond ( AIC ), trading at a 8.5% yield-to-worst
• mREIT RC 6.2% 2026 bond ( RCB ), trading at a 8.3% yield-to-worst

For further details see: