Baby Bonds: Monster Yields With Less Risk

Don't want to stomach the volatility of high-yield business development company stocks like Prospect Capital (PSEC 0.92%) or Ares Capital (ARCC 0.44%)? 

Do you fear Main Street Capital (MAIN 0.55%), Fifth Street Finance (NASDAQ: FSC), or Apollo Investment Corp. (AINV 0.87%) might slash their high dividends in the future?

There might be a perfect alternative just for you.

Meet BDC baby bonds -- small, publicly traded "notes" that pay routine quarterly interest to investors. Unlike traditional bonds, which require a minimum investment of $1,000, these baby bonds can be had for as little as $25 each, making them attractive to income investors on a budget.

Why baby bonds?
Baby bonds pay a high rate of interest (5%-8%) while offering more protection than the common stock. Baby bonds are paid after all other debt obligations of the BDC, but before shareholders. Thus, before a BDC can pay a dividend to its shareholders, it has to first cover its obligations to baby bond investors.

Baby bonds are a good way to grab high yields from BDCs with less price and dividend risk, making them suitable for investors with a lower risk tolerance.

Baby bonds offer a consistent interest rate until they mature at a specific time in the future. In between, there is often a "call" date, after which the BDC can call the baby bonds, pay investors par value, and cancel the notes.

Here's a list of available baby bonds by BDC:

Ares Capital Corporation is the biggest and one of the oldest business development companies. Ares Capital provides very good protection for its baby bond investors, as it finances most of its assets (71% of outstanding debt as of the last quarter) with unsecured financing.

Because it finances itself with mostly unsecured debt, a majority of Ares Capital's assets are safe in the event of a market decline and default. A high level of secured debt was behind the failure and collapse of BDCs during the 2008 financial crisis. Ares Capital operates with minimal secured debt, which is reflected in its lower-than-average baby bond yields.

Prospect Capital is the second-largest BDC, with a balance sheet in excess of $4 billion. Like Ares Capital, the company has financed itself primarily with unsecured debt, protecting its assets in a downturn. Some 86% of its assets are not pledged to debt ahead of the baby bonds, insulating baby bonds from default risk.

Prospect Capital's notes differ in that they cannot be called before their maturity date. Thus, investors who buy the 2022 notes can know with certainty their expected return when the notes mature. The attractiveness of these notes is evidenced by the fact they trade above par value.

Main Street Capital is one of my favorite small BDCs. This tiny middle market lender has some of the best credit quality of all the BDCs, competing for smaller deals that are off the radar of larger business development companies. Main Street Capital's notes offer a yield close to the common stock, giving investors a way to get high dividends without the risk of a declining stock price.

Fifth Street Finance has two baby bond issues, both of which trade below par. The current yield of 6.2% and 6.67% should be attractive for investors who want access to Fifth Street Capital with lower downside risk.

Investors should note that in recent quarters Fifth Street Finance has not earned its dividend on the common stock. Thus, the company could be poised for a dividend cut. That's not a problem for baby bond investors, who get the stated rate of interest as long as the company can pay. (As of today, it can easily cover the interest costs on its baby bonds and other debt financing.)

Apollo Investment shot for the long haul when it issued new baby bonds in 2012 and 2013. Its notes won't mature until the 2040s, so these notes are best for investors comfortable with the wait.

All in all, there are likely better opportunities in shorter maturity notes from other BDCs, given that these are unlikely to be called for decades, if at all. The small, extra 1% yield on Apollo Investment's longer-dated baby bonds may not be worth the necessary holding period. Even still, those who like Apollo Investment's common stock should love its baby bonds given the additional level of safety.

Bank on baby bonds
Baby bonds can be a great way to invest in your favorite BDC with lower risk than the equity. Their small $25 denominations make it easy for investors to compound quarterly distributions by purchasing more bonds with each interest payment. For BDC investors, baby bonds are a great place to store cash while waiting for your favorite BDC to sell at a price you'd like to buy.