A Forgotten Investment Worth Considering: Exchange-Traded Bonds -- Journal Report
By Eric Uhlfelder
With most Treasurys yielding under 2% and savings accounts yielding even less, individual investors are hard-pressed to figure out what to do with money they don't want exposed to material market risk.
One viable alternative is bonds that trade on stock exchanges, known as exchange-traded bonds.
About $19 billion of these securities trade mostly on the New York Stock Exchange, with many investment-grade offerings generally yielding between 5% and 6%.
While tiny compared with the traditional $9.3 trillion corporate-bond market, exchange-traded bonds generally offer more transparency than traditional debt offerings. That's because investors who buy them have the same ease of access to bid and ask information, current yield and limit orders they enjoy when buying and selling stocks, says Kevin Conery, fixed-income trading desk analyst at Piper Jaffrey.
Exchange-traded bonds also have other features that individual investors might find attractive.
These securities are issued in $25 bonds, compared with $1,000 for traditional corporate bonds. They pay interest on a quarterly basis versus corporate issues that pay semiannually. And because issuers can typically call exchange-traded bonds five years after their initial offering at par and any point thereafter, the yields are often higher than traditional corporate bonds issued by the same company.
Companies are willing to offer higher yields on exchange-traded bonds because the five-year call features gives them more flexibility to refinance debt if rates fall or eliminate it altogether if the money is no longer needed -- something that $1,000 corporates can only do closer to maturity, if at all.
That five-year call feature also can reduce the overall volatility of these bonds (as long as they aren't suffering from credit issues), especially after the call date has passed. The reason: Prices tend to trade close to par within a year or two of the call and anytime thereafter.
Consider the long-term senior bond of internet-auction giant eBay Inc., which is listed on the NYSE under the symbol EBAYL. This investment-grade offering currently yields 5.59% and is trading at $27.
By comparison, a traditional 4% coupon bond from eBay that matures in 2042 trades at 99.54 (or $995.40 per bond) and yields 4.14%. And while individuals can make any size purchase of exchange-traded bonds, there is a minimum online bid of 10 corporate bonds, or $9,954.
With many online major brokerages having eliminated trading fees, exchange-traded bonds can be bought and sold without cost. However, because these bonds are thinly traded, investors need to use limit orders to ensure efficient pricing.
Barry McAlinden, a fixed-income strategist at UBS Global Wealth Management, cautions investors not to mistake the ease of buying exchange-traded bonds with reduced need for due diligence.
"While their returns and ostensible safety can be enticing," says Mr. McAlinden, "there are many variables that need to be considered before investing and special caveats that may come into play during difficult times."
Among the things investors need to consider:
Bond interest is taxed as ordinary income. For higher-income households, this is going to be a much higher rate than the up-to-20% rate at which qualified dividends from common and preferred stock dividends are taxed. As such, tax-deferred retirement accounts might be an ideal place to hold these bonds.
Some of these securities are junior subordinated debt, meaning they have a lower-priority claim against assets if a company goes into bankruptcy. While senior bonds can't miss payments without triggering a default, junior subordinated debt can typically defer interest payments for up to 10 years without doing so. That said, such deferrals are rare. As UBS's Mr. McAlinden explains, "Such a deferral would wreck any firms' plans to access capital markets going forward."
If investors are hoping to benefit from the bond rally -- due to additional interest-rate cuts -- they shouldn't count on it. Piper Jaffrey's Mr. Conery explains such a price rise is only likely if there is at least 3.5 years before the bond is callable. "Prices of bonds with shorter call dates will likely trade closer to their call price," says Mr. Conery, regardless of minor changes in interest rates.
Still, the hunt for yield is leading some investors to take on principal risk.
The municipal-bond insurer Assured Guaranty Municipal Holdings (AGO-B) A-rated 6.875% ultralong-term exchange-traded bond is trading at $27.50 and can be called anytime with 20 days' notice. While the current yield of 6.36% looks enticing, a call at this price would result in a 10% capital loss. To break even, new investors would need the bond to remain outstanding for at least a year and a half.
Because the aforementioned eBay bond trades well above par, its effective annualized yield would be reduced to 1.81% if the company calls the security a year from now -- its initial call date. (See table.) Effective yield will rise the longer the bond remains outstanding as investors receive more quarterly payments.
Maturity dates also are important, especially if that date stretches into the next century. The longer the maturity date, the more volatile pricing can be, especially when interest rates move. Pricing is based on yield and credit spreads over equivalently termed Treasurys.
Not all exchange-traded bonds are rated. That could mean the company is confident that its issue will be well subscribed to without a rating, but it also could indicate a company that doesn't want to pay for a mediocre grade.
Quantumonline.com maintains a free database to help investors get started understanding the exchange-traded bond market.
Mr. Uhlfelder writes about global capital markets from New York. He can be reached at firstname.lastname@example.org.