As the name suggests, baby bonds are fixed-income securities with the size characteristics of babies in the sense that their par values are small. Baby bonds have a par value of less than $1,000 but typically range in values between $25 and $500. A sample baby bond from New Mountain Finance Corporation is depicted below (as of January 4, 2021):
The notes/bonds were issued at $25, and as a result of a change in the yield required, the bond is trading at $25.28. The coupon rate is 5.75%, and since the bond is trading at $25.28, the yield is slightly lower than 5.75% (5.67% as of January 5, 2021).
The usual maturity range for baby bonds is five to 15 years. However, even 50-year bonds are available in the market. The bonds are also frequently issued by state and local governments, such as municipalities and counties. As a result of the taxation power of such entities, the credit and default risks are low. Therefore, municipal baby bonds are usually highly rated (A or above).
A significant amount of baby bonds are issued as zero-coupon bonds. These bonds do not pay any intermediate interest/coupon payments and just pay the par value (generally $25) at maturity.
Since they are issued at a significant discount, the investment amount is reduced even further. For example, a zero-coupon bond similar to the previous example but with no interest payments will cost $21.09 with three years to maturity and provide a 5.75% return.
Advantages of Baby Bonds
Baby bonds are advantageous for several reasons. They include:
Low prices lead to higher liquidity for the bonds.
They trade on an exchange and hence have low credit risk.
Higher liquidity also helps the issuer to sell the bond at a premium.
Small investors who cannot invest in larger denomination bonds can also invest.
Governmental issuers provide tax-free income from such bonds.
Investors who usually invest in larger denominations can diversify into a number of baby bonds.
Disadvantages of Baby Bonds
Despite their significant advantages, baby bonds come with their own set of drawbacks, which may include:
A large proportion of baby bonds are callable, which means that the issuer can call them back and pay the agreed principal. Investors lose out on a good investment option because bonds are feasible for recall only when rates fall and their value increases.
While the bonds offer good liquidity, often during downturns, a decrease in the liquidity leads to wide bid-ask spreads, which could lead to lower returns for those that must sell.
The issuers are generally the smaller companies who would otherwise not attract much investment with $1,000 bonds. Smaller companies come with greater default risk.
Since baby bonds are not collateralized, they come with a comparatively higher credit risk than the similar collateralized bond/debt. Therefore, they are lower in the payment hierarchy of the company.
As a result of lower face value, transaction and administrative costs are generally higher on a percentage basis.
Other Baby Bonds
Baby bonds may also refer to the policy proposed by economists William Darity and Darrick Hamilton in 2010, which attempted to reduce the racial income inequality in the U.S. They proposed that the families in the lower quartile based on wealth should get $50,000 to $60,000 for their newborns. The said amount invested in federally managed funds can be accessed by the newborns when they turn 18. The bonds were slated to significantly reduce wealth inequality. However, the policy remains unimplemented.
Most recently, Cory Booker, a U.S. senator and a former Democratic presidential candidate, proposed a similar plan to provide each family of four people with an annual supplemental payment amount based on their income level. The supplemental payments would increase as income in relation to the federal poverty line decreases. The proposed payments are depicted below:
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