Exchange Traded Debt or Baby Bonds are debt instruments that trade on exchanges. They trade and have similar characteristics as Preferred Stocks. They are typically called Senior Notes, Junior Notes, and a few other names but they are basically the same thing. Baby Bonds have the following features:
- They pay out fixed interest on a regular basis – typically monthly or quarterly. This is the same as a typical Bond.
- They typically have a par value of $25. Par value is the face value of the Baby Bond which is used to determine the interest amount and is also the value the company must pay if they re-purchase it from holders. For instance, if a Baby Bond has an 8% stated interest rate, that means it will pay out $2.00 a year (8% X $25) no matter what the current trading price of the Baby Bond.
- They have a “call” date specified in the prospectus at IPO which permits the company to re-purchase it from holders for par value. Typically call dates are 5 years after IPO but this can be sooner or later.
- They all have a maturity date which requires the company to re-purchase them. This typically ranges from 2 years to near 100 years.
- All interest payments are required and cannot be put on hold. If a company misses an interest payment, the Baby Bond is in default.
Here are some more specific details on Baby Bond characteristics:
- Call Date – This is the date in which the issuing company has the right to repurchase (call) the Baby Bond from all the holders at the par value. This is typically 5 years from the IPO date but it could be more or less. If the price of the Baby Bond has risen over time to be well over the par value, as the call date approaches, the price will normally migrate back down to par.
- Ratings – Baby Bonds can be rated by Moody’s’ S&P, or other rating agencies if the issuing company wants to pay for this service. Typically, investment grade rated Baby Bonds pay a lower dividend than speculative or non-rated ones.
- Current Yield (CY) – The current yield is what an investor can expect to receive in interest based on the current trading price. If the price is below par, the rate will be higher than the stated dividend and vice versa. For instance, if an 8% Baby Bond is trading at $27 a share, the current yield is 7.4% ($2.00/$27.00). This fluctuates with prices.
- Yield to Call (YTC) – This is the yield based on the Baby Bond being called at par value on the call date. As mentioned earlier, if the price is well over the par value, as the call date approaches, the price will normally migrate back down to par. This will create a capital loss to offset the dividends and the YTC is an important item to monitor, especially when the call date is 18 months or less away
- Yield to Maturity (YTM) – This is the yield based on the maturity date. The issuing company is required to buy back the Baby Bond at par and the price will tend to gravitate to par as this date approaches.
As with Preferred Stocks, some ticker Symbols for Baby Bonds are not standardized across the different brokerage firms. But once you determine the process used by your individual firm, it will be easy to know the conversion. Many Baby Bond symbols are not hyphenated but for those that are, your brokerage firm and financial sites may use: XYZ-A, XYZPRA, XYZ-PA, XYZ.PRA, XYZpA, or XYZ’A.
Unlike large Bonds, Baby Bonds trade on the NYSE and your brokerage firm normally charges the same trading fees as they do for common stocks. They do not trade on the OTC markets first as Preferred Stocks.
The two primary risks in Baby Bonds include credit risk and interest risk. Credit risk is basically the credit worthiness of the issuing company. If the company appears to be headed for issues and possibly bankruptcy, the Baby Bond prices are doing to decrease. Interest risk is the risk that prices will fall as interest rates increase (prices and yield go in an opposite direction). This is because investors can get higher yields from lower risk investments such as Government Bonds, CDs, Savings Accounts, etc. There always has to be a delta between risk free and risk investments. If you can get a return of X% from a risk-free investment, how much above X% would you need in order to make it feasible to invest in a risk asset?