If you are making the switch from saver to investor, one of the best places to start is with bonds. Bonds provide safe, consistent income with the chance for some capital appreciation.
Treasury bonds are a safe haven for investors because they pose no credit risk (meaning they are considered risk-free). However, if you crave a little more yield, you’ll need to go further off the beaten path.
Welcome back to the Investing for Interest 101 Series (101, 102, 103, 104, 105, 106, 107, 108, 109, 110, 111, 112), my favorite series of all time. Let’s discuss how to squeeze more yield from your bonds.
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Why Treasury Bonds? Treasury Bonds come in all shapes, sizes, durations, and yields. They are easy to purchase directly from the TreasuryDirect.gov website.
When the Federal Reserve raises interest rates, this can cause Treasury yields to increase as well. However, things become tricky if you plan to sell your treasuries.
Your treasury bonds compete with current bond yields. For example, I bought a lot of 30-Year Bonds at 1.5% during the 2020 pandemic. Investors rushed to safety, causing prices to increase and yields to decrease (they act inversely).
Today, my 1.5% bonds are worthless if I try to sell them. Let’s say I sell a $200 bond with a 1.5% coupon. I might get $120 for it. You see, it needs to match the 4% yield investors can get currently—the price must go down for the yield to increase.
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Why Baby Bonds? Let’s welcome baby bonds to the show. Baby bonds are pretty much preferred shares but pay interest instead of dividends.
Unlike treasury bonds, which trade versus current rates, baby bonds have other elements to help us find discounts.
Baby bonds also trade versus interest rates, but their companies can also fall out of favor. Baby bonds trade on the stock market, which can sometimes be irrational or emotional.
Income investors can find heavily discounted baby bonds with a solid payment background and a strong company.
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Baby bonds redeem at par. Most baby bonds have a par value of $25. Therefore, if you can find bonds at $20, you will get a higher yield and capital appreciation (to $25) when the company redeems the bonds.
This makes hunting for baby bonds a fun sport. And you will be searching for baby bonds because they are rarer than preferred shares.
I have two baby bonds I have purchased over the years. There are a few more I am tracking as well. The best way to find them is to read articles on SeekingAlpha, like this one from Rida Morwa.
Treasury Bonds vs. Baby Bonds. Why do I compare these two types of bonds? As investors, it’s good to understand all the options we have on the table. Let’s look at some of the reasons to invest in each.
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Amount of purchase. Baby Bonds are rare, which means the spread can be expensive. The spread is the difference between the bid and ask price.
Therefore, if you are attempting to buy, say, $5,000 worth of a HOWR.L baby bond, your price may be higher because it takes more work to find these shares.
On the other hand, Treasuries can sell for up to millions of dollars. Treasuries are the way to go if you want to invest $100,000.
Taxes. Both types of bonds pay interest, which the government taxes at your ordinary income tax rate. However, treasuries are not subject to state tax, which can be a big deal if you live in high-tax states like New York or California.
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Speed of purchase and simplicity. Treasuries go to auction once a month. You’ll need to get your money into the TreasuryDirect website before the auction and make the purchase.
You also don’t know the price of your bonds until after the auction, so you’ll need to have more in the account than the bond price.
For example, you want to purchase a $1,000 30-Year Treasury Bond. The auctioneers may price the costs per $100 at $100.50. Your bond thus costs $1,005.
Trust me; I’ve embarrassed myself not knowing how the system works. You can see daily rates on bonds and somewhat predict the cost per $100, but it takes some work.
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Baby bonds trade on the stock market. What you see is what you get. Again, if you buy a lot, the spread may increase, but for the most part, you can buy and sell at a moment’s notice.
How they fit into your portfolio. Treasuries can be part of your hedging plan against the stock market. If you understand how bonds work (read “The Bond Book”), they may also be part of your emergency fund.
Baby bonds are part of your income-investing portfolio. You want to find the safest baby bonds with the highest yields.
Think of searching for baby bonds as going to different garage sales. You are looking for the diamond in the rough, where you can get 8% yields and $5 capital appreciation per bond.
If you follow preferred shares and baby bonds long enough, you’ll start to find great deals. I love finding baby bonds and putting $200 into these products.
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There is something satisfying about receiving interest from baby bonds. It’s like being in a cool club or knowing a secret everyone else doesn’t.
Using them both effectively. You can use both Treasuries and Baby Bonds together. I would not dollar-cost average into either—they have specific times where they perform best.
For treasuries, set a minimum yield you expect before making a purchase. For example, after getting burned, my minimum yield is 4% on 30-year bonds.
For baby bonds, you may set a minimum yield, but you can also factor in capital appreciation. For example, the yield may only be 6%, but you could receive $8 in capital appreciation for each bond.
The idea for both these types of bonds is to understand their future outlooks—that makes us investors.
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Conclusion. You may find yourself buying $200 in Treasuries one month and $200 in baby bonds the other.
You’ll start to see the fruits of your labor as your income increases exponentially. Eventually, you’ll receive enough interest from Treasuries to purchase more baby bonds. That’s an amazing feedback loop I call high-yield bond reinvestment.
Your portfolio is only as strong as your knowledge. Baby bonds are a rare commodity but can help increase your income and capital appreciation.
Every investor follows Treasuries because their yield sets the stage for all other investment products. You can leverage treasuries for safety, income, and hedging if you understand their nuances.
As long as you know your risk tolerance and investment strategy, you can use Treasuries and Baby Bonds as flexible instruments to build wealth. Good Luck!
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