What are Baby Bonds?
Baby Bonds are defined as debt instruments issued in the small denomination (usually $25 face value against the normal $1000 face value of bonds) and mostly unsecured and tradable on exchanges. These fixed-income securities attract the fancy of Retail Investors who were not able to invest much in larger denomination bonds. Baby bonds are issued by a wide array of issuers, including corporate, state governments, municipalities, etc. to fund projects with long gestation periods and heavy capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. requirements.
Baby Bonds are normally issued as zero-coupon bonds, which means they are issued at a discount to their par value, and usually, companies with small issue sizes come up with such issues to ensure enough liquidity due to the small ticket size of these bonds.
In short, Baby Bonds are unsecured bond offerings that enable small retail investors to invest a small sum of money and reap the benefits of investing in bonds without the need for investing big sums of money, which are normally required for normal bonds.
Example of how Baby Bonds Work
Let’s understand Baby Bonds with the help of a few hypothetical examples:
Jason is interested in diversifying his portfolio by investing a portion of his investments in bondsInvestments In BondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.; however, he wants to keep his investment limited up to $1000. He has two options:
- Option 1: Invest in a single bond of the face value of $1000.
- Option 2: Invest in baby bonds of a utility company that offers baby bonds in a small denomination of $50 and offers a high yield and invest in the municipal bond of face value $500, thereby obtain diversification benefits as well.
Thus Baby Bonds offer Jason to enjoy diversification, high yield even with less investment. However, it is pertinent to note that these benefits come with an additional risk in the form of Unsecured Nature, less liquidity compared to traditional bonds that come along with Baby Bonds.
Baby Bonds in the US
These bonds have their origin in the US. The first Baby Bonds started in the US in 1935 when the then President Franklin D. Roosevelt created the Baby Bond Program to encourage the habit of saving among the American Population and channelizing of those savings for financing government development programs which are long term in nature. However, now they are issued by Municipalities, Corporations to finance their long term projects. These Bonds are tax-exempt in the United Kingdom.
It recently got a lot of attention when Democratic Presidential Candidate for the next year Presidential Elections in the USA, Cory Booker, put up the Baby Bond Proposal under which government would provide every child born in the USA with a $1000 initial contribution and $2000 additional contribution year on year till the child attains adulthood based on the family Income and as per estimates due to this Baby Fund contribution kids belonging to the richest families will get a contribution to the tune of $1700 while those belonging to the poorest families can gain up to $46000 which can be used for their higher studies and retirement needs.
Advantages of Baby Bonds
- They are traded on stock exchangesTraded On Stock ExchangesStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ., which provides liquidity and efficiency in the purchase and sale of such bonds.
- They are mostly tax efficient and offer a higher yield in comparison to the normal bonds due to the callable feature inbuilt in them.
- Baby bonds holders have a preference over the assets of the company than equity shareholders in the unlikely event of liquidation of the business.
Disadvantages of Baby Bonds
Just like a Financial Instrument, Baby Bonds also have a lot of Disadvantages, few of them are enumerated below:
- Most of the baby bonds are issued by companies with a callable feature, which means that these bonds can be called back by the issuing company after a particular period, which can lead to investors of these bonds losing out the interest rates and makes them susceptible to reinvestment riskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity. into lower-yielding bonds.
- Due to the small issue size of these bonds, it becomes really difficult to sell such bonds into a market downturn due to limited liquidity arising on account of the small issue size. The Bid-Ask spread can be high in the case of baby bonds, and the economic downturn it aggravates further making them illiquid.
- These bonds are largely unsecured, and as such carries, a higher amount of Default risk with limited or no collateral for recovery as Secured Creditors have first right over the assets of the company in the case of Default.
- The cost of administration, including redemption cost, is higher in the case of Baby Bonds due to the larger number of bond certificates due to small Face Value.
- These bonds are usually issued by those Issuers who are unable to attract large institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples. due to lack of access or Issue Size.
- These bonds are normally issued with the face value of $25 to $500, however mostly in the denomination of $25.
- The maturity of this bond varies from a minimum of 5 years and can extend up to 84 years ( as per the listed baby bonds available in the market).
- These bonds are mostly callable at the option of the issuer, which in any case, will not be less than five years from the date of issue.
- Baby bonds are always unsecured and offer a high yield compared to normal bonds due to the additional risk and callable feature that is advantageous to the issuer.
Baby Bonds are exchange-traded debt that enables small investors to reap the benefits of investing in bond instruments with a face value as low as $25 and also allow companies with small issue size to easily float there bond issue and at the same time, ensure sufficient liquidity. Baby Bonds, just like any other financial instruments, has its pros and cons, an investor should keep these points in mind before making their investments.
This has been a guide to what are baby bonds and its definition. Here we discuss an example to understand how baby bonds work with its advantages and disadvantages. You can learn more about financing from the following articles –