The Best Fixed-Rate Bonds to Buy Now

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We Don’t Write Much about Fixed-Rate Bonds at Cabot. But these Four are Worth Your Consideration.

If we’ve heard it once, we’ve heard it from hundreds of subscribers: What are the best fixed-rate bonds to buy? Ever since late 2008, income investors have been in a pickle—after some rate hikes, the Fed is easing again, and most money market funds are yielding zilch, forcing investors to dive into dividend stocks to earn their 3% or 4% yields.

I have nothing against dividend stocks, of course – 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—getting 4% to 7% interest every year (sometimes more) with a lot of safety is especially attractive when longer-term government bonds are yielding less than 1%. In a low-interest rate environment, most investors don’t believe such safe, steady gains are possible.

But they are! And it’s not achieved through a complex system of options or speculative instruments that you have no confidence in.

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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.

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.

Liquidity: Nearly all preferreds and baby bonds trade relatively sparsely. 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. What does that mean? That the company has the right to “call” back the security, paying owners $25 per share in exchange. (Companies will do this occasionally to “refinance” the bond and cut their costs.) 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. So the payments are much safer 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.

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 are steady, but when rates rise, there’s nothing stopping these perpetual preferreds from falling sharply in value and staying down for years.

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% (twice as many assets as total liabilities), and when they issue 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 recently. Like ordinary preferred stocks, they have no maturity, but their special floating rate feature protects them from future rises in interest rates.

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). Thus, if rates stay low, you’ll get a reasonable payment, but if they rise in the years ahead, these issues will tend to hold their value, as investors know the payments will increase along with interest rates.

The 4 Best Fixed-Rate Bonds Right Now

So 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. (If it was, you’d be getting 1.0% interest, like you do in a money market fund.) 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 Baby Bond (ECCX)

Coupon: 6.6875% ($0.418 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: 4/30/2021

Maturity Date: 4/30/2028

Eagle Point is a closed-end fund that invests in collateralized loan obligations (CLOs). Please note that these are not the collateralized debt obligations (CDOs) that nearly brought down many big banks during the 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. Thus, Eagle Point itself is almost like a juiced up high-yield bond fund. Indeed, when high-yield bonds were under duress during the 2015-2016 energy price collapse, this fund’s net asset value fell from $19.63 per share in November 2014 to as low as $13.02 per share in March 2016, a 34% haircut. And the fund saw its value per share fall more than 40% during the first half of this year (pandemic), though it’s already recovered a chunk of that.

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.

As mentioned above, 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 ECCX, the coverage must be three-to-one! Eagle Point is even more conservative on that front (a good thing); the funds’ assets total about $442 million, compared to $94 million of fixed-rate bonds (asset coverage of nearly five-to-one), which provides a huge level of cushion for investors in the baby bond. (Eagle Point also has another $47 million or so of term preferred stock—another form of leverage—but ECCX is higher up on the food chain than the preferreds.)

As for income, there’s also a giant amount of safety for ECCX. In the first three quarters of 2020, even as the world turned inside out, Eagle Point brought in $49 million of investment income, but it had interest obligations on its bonds of just $54.9 million or so—10-to-1 coverage! As we’ve seen this year, even a horrible credit crunch wouldn’t come close to threatening Eagle’s ability to pay on these bonds.

Finally, the company has no debt or preferred maturities until 2026—so there’s no chance of a “forced refinancing” causing issues for many years.

ECCX has a slightly longer time until maturity (2027) than we’d prefer, and it’s callable (at 25 per share) in April 2021. However, because ECCX is Eagle Point’s lowest-yielding piece of leverage (it has preferreds at 7.75% and another debt issue at 6.75%), it’s unlikely any call will occur—and besides, it’s been trading just below par for months now, eliminating any risk of losses in the unlikely event the bond gets called next year.

Best Fixed-Rate Bond #2: Energy Transfer Partners Series E Fixed-to-Floating Preferred Shares (ETP-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 $95 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.

The common stock of Energy Transfer has had a tough time in recent years, like many of the big MLPs, with investors worried about the debt load (even though that’s come down quite a bit) and energy prices. But business has been solid for years, even through 2020’s pandemic—business has fallen some for sure, but EBITDA ($7.9 billion) and distributable cash flow ($5.4 billion) were still very healthy in the first nine months of the year.

Interestingly, the company actually halved its common dividend in recent months, but that’s going to be a good thing for this preferred stock, as the extra cash flow (about $1.2 billion per quarter) will go to debt reduction. There also aren’t any major debt maturities next year, so a credit crunch (which we don’t expect anyway) won’t hurt the firm’s ability to run its ship.

All in all, Energy Transfer cranked out about $2.7 billion of operating profit in Q3, yet its interest and preferred stock payments were just $670 million or so—more than four times coverage. In other words, even if Energy Transfer’s cash flow gets cut in half (almost certainly not happening), it would still have more than enough money as it needs to meet its interest obligations and preferred payouts.

ETP-E is a fixed-to-floating issue, paying a solid 7.60% annually through May 2024, and then paying 5.16% plus three-month LIBOR (trading around 1.9%). Combine that with the fact that it’s not callable for three and a half years, and investors are likely to earn a solid return here from the dividends, while ETP-E should remain relatively resilient even in the event interest rates head higher down the road.

Best Fixed-Rate Bond #3: Fidus Investment Baby Bond (FDUSG)

Coupon: 5.375% ($0.336 per share, per quarter)

Interest Payable: First of February, May August and November

(Note: Ex-dividend dates are usually two weeks before the pay dates)

Payments will count as ordinary income (fully taxable)

Callable as of: 11/1/2021

Maturity Date: 11/1/2024

Okay, okay, 5.375% isn’t the most thrilling thing in the world, but we’re putting this bond in here because it’s very short-term (matures in just less than four years) and looks safe. Nothing wrong with that combination.

Fidus Investment (common stock ticker is FDUS) is a mid-sized business development company (BDC) that’s been public since 2011 and has $748 million of assets, mostly in the form of debt investments in various middle market private companies ($627 million), though it also often buys equity stakes in these firms, too, giving us a little “juice” for total results.

In all, it has investments in 63 firms in a variety of industries. To be fair, these loans/investments are a bit lower on the food chain than some other BDCs; just 21% of its loans are first lien, for instance. But there are still plenty of reasons this should be a very safe, easy return.

As with most BDCs, the balance sheet is terrific—liabilities are less than half of assets. Moreover, investment income even during this year’s economic downturn has come in at more than four times total interest expense, so even if there’s another economic canyon (which we don’t expect), Fidus will have more than enough money to pay its obligations.

Just as important is the structure of Fidus’ liabilities—it doesn’t have any debt maturing before 2023, so there’s basically no chance of the firm getting squeezed even if there was a general credit crunch (no need to refinance any bonds, and plenty of income to cover interest costs).

All told, we think FDUSG is a solid, conservative issue for those willing to collect some interest in the years ahead.

Best Fixed-Rate Bond #4: Annaly Capital Series I Fixed-to-Floating Preferred Shares (NLY-I or NLYprI at most brokerages)

Coupon: 6.75% fixed annually ($0.422 per share, per quarter) through 6/30/2024; rate will then float at 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: 6/30/2024

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 tighten and the occasional pop higher in interest rates damages their investments.

However, for income investors, the preferred stocks of many in the group are very safe. Why? Because 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 ($89 billion in assets!), and its various fixed-to-floating preferred stocks have a ton of coverage, which is why we think it’s a good investment. For instance, Annaly pays out around $34 million or so of preferred dividends every quarter (it has many series of preferreds, but the I is our current favorite), which is not only tiny compared to its overall net asset value ($14 billion) but also pales in comparison to its common stock dividend ($310 million per quarter).

Even comparing the total value of all preferreds (less than $2 billion), the company could buy them all back (in theory) seven times over, especially as so many of its assets are in extremely liquid agency mortgage securities. Throw in the fact that management has navigated many tough environments  (it’s been public since 1997), including this 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 I doesn’t have a maturity date—but it does have a floating feature that should protect the preferred from falling much if interest rates rise. It will pay out at a 6.75% rate no matter what through June 2024, and after that, the preferred’s payment will be 4.99% plus three-month LIBOR, which tends to move up and down with the Federal Reserve’s action.

Right now, LIBOR is just 0.25%, but there’s still three and a half years of 6.75% coupon payments coming no matter what—and NLYprI can be had below par, too.

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.

Michael Cintolo

Your Guide to Winning Growth Stocks

Michael Cintolo is a growth stock and market timing expert. His Cabot Growth Investor, with its legendary Model Portfolio, is recommended for all investors seeking to grow their wealth.

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*This post has been updated from an original version that was published in 2016.


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