Rising interest rates have been the stock market’s main bugaboo since late 2021, as the Fed has tightened in a huge way to combat inflation and market interest rates have generally followed. But there are two sides to every coin, and the good news about this rate rise is that, for the first time in 15 years, income investors have a bastion of lucrative opportunities in fixed-rate bonds and other income-paying instruments.
Of course, we have nothing against dividend stocks—and nor should you. In fact, I highly recommend subscribing to our Cabot Dividend Investor advisory, which focuses on finding the best dividend-paying stocks, whether it’s high yield, safe income or dividend growth stocks—achieving both solid income and capital gains. (Click HERE for more information.)
But many investors are also looking for some surety through fixed-rate bonds—surety that was mostly lacking (unless you dove into risky situations) for the past many years. Now, though, there are more and more opportunities to grab 6% to 9% yields (sometimes more) with a lot of safety and to effectively lock in those yields for many years to come.
Important, none of this is achieved through a complex options strategy or by toying with speculative instruments that can quickly get in trouble should the economy get hit.
Today, we focus on three plentiful, popular types of fixed-income securities: Term preferred stocks, “baby” bonds (they’re called baby because they’re issued in $25 increments so the average investor can buy them) and fixed-to-floating preferred stocks. As with any investment, you have to know what to look for, but once you do, you can achieve the steady and safe income steam you desire. It’s a hugely underfollowed area that’s ripe with solid options.
The Best Fixed-Rate Bonds: Term Preferred Stocks and Baby Bonds
Term preferred stocks and baby bonds are very similar in how they work. Let’s talk about some of the details.
Pricing: The vast majority of term preferreds and baby bonds have a par value of $25 per share. They trade on major exchanges and are bought just like stocks through your brokerage account. Encouragingly, many bonds and what-not trade below par value these days, meaning you’ll not just get the coupon payment, but over time, the capital gain of the bond rising back to par.
Liquidity: Nearly all preferreds and baby bonds trade somewhat sparsely, maybe a few hundred to couple thousand shares per day. Thus, when buying, you want to be sure to use limit orders—if you buy at the market, you’ll often pay more than you have to. Instead, place a limit order for the day; that way you know you won’t pay more than a given price.
Callable: Almost all preferreds and baby bonds are callable two to five years after their initial issuance—meaning the company has the right to “call” back the security, paying owners $25 per share in exchange. (Companies used to do this to “refinance” the bond and cut their costs, though calls will be few and far between for a while.) Because of this, you want to avoid buying issues that are (a) priced well above $25 and (b) could be called within just a few months.
Fixed Coupons: Every preferred or baby bond has a fixed coupon rate. Most pay interest quarterly, though some term preferreds pay monthly. Of course, the big benefit is that these payouts are higher up the food chain for a company—they have to pay your interest before any common dividends. (If they pay one penny of common dividend, they must pay all the preferred payment.) So, the payments are much more dependable than a regular stock dividend.
Maturity: Every term preferred and baby bond has a maturity date, at which point the company gives you back $25 per share. Some bonds from well-respected companies have very long maturity dates—up to 60 years if you can believe it!—but there are a good number that mature in three to 10 years, which is our usual focus.
Note: Ordinary preferred stocks (often called perpetual preferreds) have similar features, but of course, they have no maturity dates. Companies never have to redeem them! That’s fine as long as interest rates were steady, but when rates rise as they have, there’s nothing stopping these perpetual preferreds from falling sharply in value and staying down for years. That’s just what we’ve seen in the past year—many high-quality issues are down in the teens!
Additional Safety Features: Some of the most common issuers of term preferreds and fixed-rate baby bonds are closed-end funds and business development companies (BDCs), which offer these securities to leverage their results for common shareholders. The good news for income investors is that both have asset restrictions that make it safer to own these securities.
Specifically, BDCs are required to have an asset coverage ratio of at least 150% – generally speaking that means for every $1.5 million of assets, they can’t have more than $1.0 million in liabilities. (There are a couple of exceptions, but those are easily checked before you buy the bond.)
Moreover, closed-end funds have even greater protections—they must have an asset coverage ratio of 200% for preferreds (twice as many assets as total liabilities), and for their debt, the coverage ratio must be 300%! Such restrictions give the fixed-rate bond investor a huge cushion of safety.
Adding a Little Flavor (and Higher Yield): Fixed-to-Floating Preferred Stocks
Fixed-to-floating preferred stocks are a special instrument that have been gaining in popularity in recent years—and now they’re paying off as rates have risen. Like ordinary preferred stocks, they have no maturity, but their floating rate means higher payments as rates rise.
Specifically, fixed-to-floating preferred stocks pay a fixed amount for the first few years of their life … but after that, will pay a floating rate (normally three-month LIBOR, which goes up and down with the Fed’s actions) plus a fixed portion (depends on the issue, but usually 3.5% to 5%). There are more and more of the fixed-to-floating issues that look very tempting today.
The 4 Best Fixed-Rate Bonds Right Now
OK, that’s enough education—now onto the more important question: What term preferreds, fixed-rated baby bonds and fixed-to-floating preferreds are our favorites?
Here are four to consider, but a word to the wise—nothing is risk-free, including these securities. It’s always possible things could go amiss, so be sure to do your due diligence before buying.
With that said, here are the four best fixed-rate bonds right now.
Best Fixed-Rate Bond #1: Eagle Point Credit 6.75% Baby Bond (ECCW)
Coupon: 6.75% ($0.422 per share, per quarter)
Interest Payable: Last day of March, June, September and December
(Note: Ex-dividend dates are usually two weeks before the pay dates)
Payments will count as ordinary income (fully taxable)
Callable as of: 3/29/2024
Maturity Date: 3/31/2031
Eagle Point is a closed-end fund that invests in the equity portion of collateralized loan obligations (CLOs). Please note that these are not the collateralized debt obligations (CDOs) that nearly brought down many big banks during the 2008 financial crisis.
CLOs have a long history of volatile-yet-juicy returns. CLOs own a collection of senior, secured, floating rate corporate bank loans, albeit with lots of leverage, and Eagle Point owns the lower tranche of the flagpole. Thus, Eagle Point itself is almost like a juiced up high-yield bond fund, leading to big dividends (the common yields nearly 15% and that’s before supplemental dividends!) but iffy stock action—the fund itself is down from 20 to 11 during the past five years and net asset value has seen a similar haircut over time.
However, as investors in the fund’s baby bond, that action doesn’t mean much. What really counts is the fund’s asset coverage ratio and the cash its investments spin off.
For closed-end funds, total assets must be at least two times the total leverage (debt plus preferred stock) on the books. And for a baby bond like ECCW, the coverage must be three-to-one! Eagle Point is even more conservative on that front (a good thing); at year-end 2022, the fund’s assets were $760 million, compared to $170 million of fixed-rate bonds (asset coverage of around 4.5-to-one), which provides a huge level of cushion for investors in the baby bond. (Eagle Point also has another $70 million or so of preferred stock—another form of leverage—but ECCW is higher up on the food chain than the preferreds.)
As for income, there’s also a giant amount of safety for ECCW. Last year, the fund brought in $118 million of investment income, but the annual payments due on its baby bonds (including ECCW) is under $11 million—10-to-1 coverage! Even the horrible early-2020 pandemic credit crunch and 2022 credit market implosion did nothing to threaten these bonds
Finally, the company has no debt or preferred maturities until 2026—so there’s no chance of a “forced refinancing” (which can occasionally cause problems) for many years.
ECCW has a slightly longer time until maturity (2031) than we’d prefer, but the coupon (6.75%, fully taxable) is solid and recently shares have recently been trading in the low 23 range (easily below par).. There will be ups and downs with the fund itself (especially if junk bonds get hit again), but this bond should be very safe and steady, paying out a solid rate of interest for many years to come.
Best Fixed-Rate Bond #2: Energy Transfer Partners Series E Fixed-to-Floating Preferred Shares (ET-E or ETPprE at most brokerages)
Coupon: 7.60% ($0.475 per share, per quarter) through 5/15/2024; then paying 5.16% plus three-month LIBOR
Dividends Payable: 15th of February, May, August and November
(Note: Ex-dividend dates are usually two weeks before the pay dates)
Security will produce a K-1 at tax time (it’s a simplified version, though, with payments generally equal to taxable income)
Callable as of: 5/15/2024
Maturity Date: None
Energy Transfer Partners is a giant master limited partnership, with assets totaling $105 billion that are spread all around the country and have a presence in most of the country’s major basins, including the Permian, Bakken, Marcellus, Eagle Ford and more. It’s even going on the offense a bit here, as it’s in the process of acquiring Enable Midstream.
The common stock of Energy Transfer has had a tough time in recent years, though it’s been on the comeback trail of late, as the top brass has reduced debt, seen cash flows increase and re-upped the common dividend back to its level from a few years ago (current yield 9.5%). Business has been solid for years, even through 2020’s pandemic—adjusted EBITDA totaled $13 billion last year while distributable cash flow came in at $7.4 billion, and the top brass sees similar figures for 2023.
Importantly, the company is self-funding, meaning it can pay dividends and invest in growth and still reduce debt. Capital expenditures should be “only” $2.5 billion of so in 2023, leaving massive amounts of cash left over (something on the order of $5 billion).
That’s music to the ears of preferred holders—the more cushion it has, the more stable the outlook for the preferred stock will be. Indeed, some math tells you about the safety here: In 2022, Energy Transfer’s distributable cash flow before interest payments ($2.3 billion) and preferred dividends ($470 million) was nearly $10.2 billion. That’s 3.7x interest and preferred payments. There are many ways to slice it, but either way, the preferred payments are super safe.
ETP-E is a fixed-to-floating issue, paying a solid 7.60% annually through May 2024; currently, the yield is a bit higher than that as the preferred sits in the low 24s, under par. But what’s interesting is what happens next year: After May 2024, the preferred will pay 5.16% plus three-month LIBOR (trading around 4.9%), which would be a yield of nearly 10%!
Of course, maybe the Fed reverses course and cuts rates a bit if there’s a recession, but to us, it’s a solid risk-reward—if the preferred is called at 25 next summer, you’ll collect dividends this year and make a bit of capital gains; and if not, the yield is likely to head toward double digits. Not bad for an issue with this much cushion.
Best Fixed-Rate Bond #3: Hercules Capital 6.25% Baby Bond (HCXY)
Coupon: 6.25% fixed annually ($0.391 per share, per quarter)
Dividends Payable: Last day of January, April, July and October
(Note: Ex-dividend dates are usually two weeks before the pay dates)
Qualified Dividends: No (fully taxable)
Callable as of: 10/30/2023
Hercules Capital is one of the bigger business development companies (BDCs) out there, specializing in debt investments (though it does do a little equity) in a ton of small, up-and-coming growth outfits; at year-end, it had north of $3 billion of assets in 120 different companies, normally with shorter-term maturities (three to four years). Unlike some peers, there’s no crypto exposure here, nor any metals, mining, oil/gas or real estate-type exposure—just a mini-venture capital firm of sorts, with a debt focus.
Last year as a whole saw investment income total $322 million, which was helped along by rising interest rates (most of their investments have floating features, so payments rise as rates rise), compared to just $63 million of interest and loan fees—a coverage ratio of five times. In terms of the balance sheet, total assets were 1.86x total liabilities, and just 2.2% of their investments were having issues, which is solid.
The firm has a few debt instruments, most of them only available to institutions. But it still has one baby bond out there, which is our focus here: It was floated nearly five years ago and matures in another 10 years, with a coupon of 6.25%. It’s not as big a yield as others, but it’s certainly safe and has a maturity to it as well.
“But what if the company calls the bonds later this year?” Well, if they do, it’s no harm, no foul; HCXY is trading around 25 (though it trades sporadically—be sure to use limit orders!), so there’s no real downside. But our guess is the firm won’t call it; the one debt instrument it floated last year had a coupon of 6%, and rates are higher than they were back then. It’s possible, but it’s unlikely the firm would be able to refinance the bond with a lower rate, and we doubt they want to reduce leverage.
Because it’s still 10 years from maturity, another sharp rise in interest rates could send the price lower, but all in all we view this as a solid way to likely lock in a 6%-plus yield for a long time to come.
Best Fixed-Rate Bond #4: Annaly Capital Series F Fixed-to-Floating Preferred Shares (NLY-F or NLYprF at most brokerages)
Coupon: 4.99% plus three-month LIBOR
Dividends Payable: Last Day of March, June, September and December
(Note: Ex-dividend dates are usually two weeks before the pay dates)
Qualified Dividends: No (fully taxable)
Callable as of: Now
Maturity Date: None
We’re not huge fans of mortgage REITs as general businesses—while they pay healthy dividends, even the best firms in the group can see their book values (and common stock prices) decrease when spreads widen (when Treasuries fall lower than the price of mortgage-backed securities), as they did last year, which led to big declines in book value.
However, for income investors, the preferred stocks of many in the group (mostly those investing in agency REITs, like Annaly) are quite safe. Why? First, because these agency securities are guaranteed by the government; there’s no default risk here, just the aforementioned financing risk as the firms lever up. Second is liquidity, as agency securities can be sold in an instant if needed.
And third is that the payments from these preferreds are tiny compared to the company as a whole, providing a ton of cushion even when the environment turns bearish.
Annaly Capital is the big dog in the mortgage rate sector ($81 billion in assets!), and its various fixed-to-floating preferred stocks have a ton of coverage, which is why we think they’re a good investment. For instance, Annaly pays out around $30 million or so of preferred dividends every quarter (it has many series of preferreds, but the F is our current favorite), which is not only tiny compared to its overall net asset value ($11 billion) but also pales in comparison to its common stock dividend ($411 million per quarter). To be fair, management said that the common dividend will likely be cut soon, but it’s still likely to be 8 to 10 times the preferred payout
Even comparing the total value of all preferreds (about $1.5 billion), the company could buy them all back (in theory) seven times over; the firm also had $6.3 billion of unencumbered assets at year-end, which is huge cushion. Throw in the fact that management has navigated many tough environments (it’s been public since 1997), including last year’s, and there’s no reason to think the preferreds won’t pay out nicely for a long time to come.
Similar to Energy Transfer’s preferred mentioned above, Annaly’s Series F doesn’t have a maturity date—but it does have a floating feature, and this one is already in place: The preferred pays a 4.99% base rate plus three-month Libor, which is currently near 5%. Indeed, for the latest quarter, the payout was just over 60 cents a share!
To this point, the spreads in the agency security market are so wide that paying ~10% on this preferred still makes a lot of sense for Annaly; plus, an issue floated by its closest peer (AGNC Investment) late last year is trading at a yield of nearly 8.5%, so it’s not like there’s a huge refinancing advantage, either.
Long story short, we think NLY-F is an interesting play: If you can get it at 25 or below, you’ll be soaking up a big (and possibly growing) yield, with no call risk. In theory, if the Fed slashed rates, that would cut the payout and hurt prices, but (a) that’s looking very unlikely, and (b) they’d likely have to cut by 1% to 1.5% to have a real impact here.
The Bottom Line
Whether you’re interested in any of these four securities or not, our main point is that term preferreds and fixed-rate baby bonds are a largely unknown area of the market for most investors. From our view, they offer the best fixed-rate bonds for income investors looking for a safer alternative to dividend stocks.
Do you own any fixed-rate bonds or preferred stocks not on this list? Tell us about them in the comments below!
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*This post has been updated from an original version that was published in 2016.
