Baby Bonds

Updated on January 4, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What are Baby Bonds?

Baby bonds refer to debt instruments issued in smaller denominations. The par value of these fixed-income securities is lower than $1000. These fixed-income securities attract retail Investors who cannot invest in larger denominations.

They are issued by an array of issuers—small companies, state governments, municipalities, etc. These are tradable yet unsecured bonds. They are issued at a discount and recognized as zero-coupon bondsZero-coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more. Most such bonds are exempt from taxation.

Key Takeaways

  • Baby bonds refer to the unsecured fixed-income securities—face value ranging from $25 to $500. It is issued by the municipalities, state government, central government, or small corporations.
  • The bonds mature within 8 to 15 years and are issued with a callable option (which can only be exercised after five years).
  • Governments issue such bonds to fund projects with long gestation periods and heavy capital expenditure.
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Baby Bonds Explained

Baby bonds are exchange-traded debts that enable small investors. Small investors can avail of bond instrument benefits with low face values—as low as $25, ranging upto a maximum of $500.

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Small companies cannot issue large bonds. But, they can issue baby bonds without compromising on liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more. In the UK, some parents save every month for ten years; in return, their children are issued tax-free baby bonds.

These bonds are not secured with any collateralCollateralCollateralization is derived from the term "collateral," which refers to a security deposit made by a borrower against a loan as a guarantee to recover the loan amount if s/he fails to pay.read more. The maturity period varies between a minimum of 5 years and a maximum of 50 years (usually between 8 to 15 years).

These bonds are mostly callableCallableA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls.read more, which in any case is not less than five years from the date of issue. Moreover, these securities offer higher yields than normal bonds—due to added risks and the call feature.

History of Baby Bonds

The first baby bond was issued by the US government in 1935. President Franklin D. Roosevelt created the Baby Bond Program to encourage the habit of saving. The government needed to fund hefty expenditures on the civil war—issued bonds.

In 1935, the US government also came up with lower denomination bonds called A- bonds; it was a kind of baby bond. Later, B-bonds, C-bonds, and D-bonds were issued in 1936, 1937, and 1938 respectively. The bonds traded at 75% of face value, and the maturity period was ten years.

Contemporarily baby bonds are released by municipal corporations, cities, and states. They are zero-coupon bonds that mature between 8 and 15 years. In the 1990s, the UK saw the emergence of savings for children. Parents contributed a certain amount every month for ten years. In return, their children received a tax-free bond fund as a lump sum of money—as soon as they turned 18.

In 2005, the UK launched a Child Trust Fund for the children—who took birth after September 1, 2002. Every child received a €250 voucher for opening an account. 

Examples

Jason is interested in diversifying his portfolio. He spends a portion of his investment on bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more; however, he wants to keep his investment limited to $1000.

He has two options:

  1. Option 1: Invest in a single bond with a face value of $1000.
  2. Option 2: Invest in baby bonds issued by a utility company that offers small-denomination bonds of $50. These bonds offer a high yield. In addition, Jason can invest in $500 municipal bonds for portfolio diversificationPortfolio DiversificationPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio.read more.

Thus, Baby Bonds offer diversification and high yield despite investing less. However, it is pertinent to note that these benefits come with additional risks. These bonds are unsecured in nature and offer less liquidity (compared to traditional bonds).

Baby Bonds in the US

In 2021, these bonds got a lot of attention. Presidential candidate Cory Booker proposed a $1000 initial contribution for every child born in the US. He also promised an additional contribution of $2000 year on year till the child attains adulthood—subject to family income estimates.

According to the proposal, a child belonging to an affluent family will get around $1700, whereas economically challenged children could benefit as much as $46000. The fund was meant for higher education and retirement needs.

Pros and Cons

The financial instrument has the following advantages:

  • Affordable: Even average retail investors can purchase baby bonds—available in small denominations—starting at $25.
  • Tax Efficient: Fixed income securities issued by the municipalities are usually free from taxes. 
  • Callable: After five years, the issuing company can call these bonds back (beneficial to the issuers).
  • Better Returns: They offer a higher yield (compared to traditional bonds) due to the callable feature.

The bond suffers from the following disadvantages:

Frequently Asked Questions (FAQs)

How are baby bonds taxed?

Bonds issued by the government, especially the municipalities, are usually tax-free. When small companies offer these bonds (with a callable feature), the returns are taxed.

How often do baby bonds pay interest?

The bonds offer annual interest of 5% to 8% (higher than traditional bonds). Investors receive interest payments every quarter.

Do baby bonds pay dividends?

Instead of dividends, bondholders receive quarterly interests. Since they are unsecured debt instruments, investors receive a higher return.

This article has been a guide to Baby bonds & definition. We explain baby bonds, how they work, “save for college” funds, pros, cons & examples from the US & UK. You can learn more about financing from the following articles –

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