In today's low-yield world, individual investors and the advisers who guide them increasingly are open to fresh ideas for generating meaningful income. In fact, this attitude is helping propel a new investment trend: investing in baby bonds issued by business development companies.
With an attractive combination of higher yields and lower risk, BDC baby bonds (so called because they are issued in small denominations) are becoming more popular.
In 2012, nine BDCs issued approximately $1.1 billion of baby bonds, compared with the two previous years, during which only one BDC issued $200 million of baby bonds. There are currently about 40 publicly traded BDCs. In the first quarter of 2013, BDCs were active issuers of baby bonds, with four issuers raising more than $300 million.
BDCs have been offering these bonds to individual investors at compelling yields. Rates currently range from about 6% to 7.5%, depending on the credit rating of the issuer and maturity of the bond. Investment-grade baby bonds have yields at the low end of the range, while noninvestment-grade ones are at the higher end for similar maturities. That compares favorably with yields on junk bonds, which are relatively similar, though the bonds are all noninvestment-grade.
Beyond the obvious yield benefits, baby bonds offer a number of other distinct advantages. With par values as low as $25, they are more accessible to investors and come with built-in liquidity. Usually listed on either the Nasdaq or New York Stock Exchange, they can be bought and sold just like a normal stock.
Baby bonds also tend to exhibit lower volatility. Unlike the stocks of their issuers, which typically fluctuate more in price, baby bonds generally have a greater likelihood of returning principal, plus interest, provided the bonds are held to maturity. Maturity can range from 10 to 30 years, with most in the 10- to 15-year range.
Many advisers regard baby bonds as an alternative way to gain exposure to BDCs — especially for investors who have lower tolerance for volatility or who need greater assurance of principal protection.
Much of the appeal of these bonds comes from the allure of BDCs themselves. They were created in 1980 by Congress to stimulate lending and offer individual investors access to the debt and equity of private small- and midsize companies, which typically is available only to institutional and high-net-worth investors.
BDCs are required to diversify their portfolios, fair-value their investments quarterly and limit leverage to a maximum debt-to- equity ratio of 1:1 (with limited exceptions). In terms of diversification, no one investment or handful of investments can dominate a portfolio. More than half of the portfolio must be in investments that represent less than 5% of total assets and no single investment can exceed 25% of assets. Further, BDCs are “pass-through” vehicles; they don't pay corporate income taxes if they pay out to shareholders at least 90% of their taxable annual net income (among other requirements).
While all BDCs share those factors, there is a lot of variation among individual BDCs, such as the strength of the management teams, the quality of the loan portfolio, whether the BDC is investment-grade, and the robustness of the risk management strategy and controls. When considering baby bonds — which are unsecured — investors need to look closely at all those elements for the issuing BDC.
One advantage for advisers and investors delving into the underlying fundamentals is that BDCs are more transparent than some private funds that invest in similar assets.
BDCs have regular SEC-reporting requirements and their financial statements are audited annually. Some BDCs and their baby bonds are rated by the major credit ratings agencies.
Despite these safeguards, some have questioned whether investors should approach the baby bond crib with care. They argue that baby bonds are a better deal for issuers than investors, pointing out that yields may be lower than expected, should an investor need to sell prematurely.
It's true that the market for BDC-issued baby bonds still is in its infancy and investors who sell prematurely may receive a lower yield. However, this doesn't render them a flawed investment. Rather, it emphasizes the importance of proper portfolio positioning and the added value of working with an astute adviser.
Dean Choksi is senior vice president of finance and head of investor relations at Fifth Street Finance Corp.