The Best Fixed-Rate Bonds to Buy Now

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—even after the recent string of Fed rate hikes, most money market funds are yielding less than 1%, forcing investors to dive into dividend stocks to earn their 3% or 4% yields.

I have nothing against dividend stocks, of course; on the contrary, my Cabot Dividend Investor 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 5% to 7% interest every year (oftentimes more) and the guarantee of getting their money back when the bond matures in a few years. In the near-zero interest environment, most investors don’t believe such safe, steady gains are possible.

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

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, closed-end funds and BDCs are required to have an asset coverage ratio of at least 200% – generally speaking, that means they have to always have at least twice as many assets as liabilities. (There are a couple of exceptions with BDCs, but those are easily checked before you buy the bond.)

Moreover, in closed-end funds, any fixed-rate bonds must have a coverage ratio of 300% – i.e., assets always have to be at least three times larger than the fund’s liabilities! Such restrictions give the income 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 during the past few months. 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, even if rates rise in the years ahead, as is likely, these issues will tend to hold their value, as investors know the payments will increase along with interest rates.

The Four 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 0.5% 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 (symbol ECCY)
Coupon: 6.75%

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: 9/30/2020

Maturity Date: 9/30/2027

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. Conversely, CLOs have a long history of volatile-yet-juicy returns.

CLOs own a collection of senior, secured, floating rate corporate bank loans, 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. (It recovered strongly soon after and the NAV is currently around $16.70 per share.)

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 are spinning off.

As mentioned above, for closed-end funds, assets must be at least two times the total leverage (debt plus preferred stock) on the books. And for a baby bond like ECCY, the coverage must be three-to-one! Eagle Point is even more conservative on that front; the funds’ assets total about $530 million, compared to just $90 million of fixed-rate bonds (asset coverage of nearly six-to-one), which provides a huge level of cushion for investors in the baby bond. (Eagle Point also has another $90 million or so of term preferred stock—another form of leverage—but ECCY is higher up on the food chain than the preferreds.)

As for income, there’s also a giant amount of safety for ECCY. Eagle Point brought in $65.3 million of investment income during 2017, but has interest obligations on its bonds of just $6 million or so—more than 10-to-1 coverage! Even a repeat of the 2015-2016 credit crunch wouldn’t come close to threatening Eagle’s ability to pay on these bonds.

ECCY was only launched last September, and while it has a slightly longer time until maturity (2027) than we’d prefer, it’s not callable until September 2020, so you don’t have to worry about it getting called away any time soon. ECCY is our favorite conservative baby bond out there right now.

Energy Transfer Partners Series C Fixed-to-Floating Preferred Shares (ETP-C or ETPprC at most brokerages)

Coupon: 7.375%

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 (though it’s a simplified version, with payments generally equal to taxable income)

Callable as of: 5/15/2023

Maturity Date: None

Energy Transfer Partners is a giant master limited partnership, with assets totaling $77 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 ETP has had a tough time in recent years, like many of the big MLPs, with investors worried about higher interest rates and turned off by the “parent-son” corporate structure. But business remains in great shape for Energy Transfer—in the first quarter of this year, revenues rose 20% from a year ago, EBITDA rose 30% and distributable cash flow lifted 29%. Moreover, management sees more growth ahead as projects come on-line.

Add it up and we see a lot of safety in this preferred stock. The company is cranking about $1.6 billion of cash flow, compared to about $400 million of interest expenses and preferred stock payment—a healthy four-to-one coverage ratio. Said another way, if Energy Transfer’s cash flow gets cut in half (almost certainly not happening), it would still have twice as much money as it needs to meet its interest obligations and preferred payouts.

(ETP also pays about $1 billion per quarter of common dividends, so if worse came to worse, cutting those payouts would provide a huge amount of money to keep preferred owners happy.)

ETP-C just hit the market in April of this year; its first payment was in mid-August. As with AGNCN above, ETP-C is a fixed-to-floating issue, paying 7.375% annually through May 2023, and then paying 4.53% plus three-month LIBOR (which is already up to 2.35%). Combine that with the fact that it’s not callable until 2023, and investors are likely to earn a solid return here from the dividends, and ETP-C should remain relatively resilient to higher interest rates given the floating feature.

OFS Capital Fixed-Rate Bonds (symbol OFSSL)

Coupon: 6.375%

Interest Payable: End of January, April, July and October

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

Payments will count as ordinary income (fully taxable)

Callable as of: 4/30/2020

Maturity Date: 4/30/2025

OFS Capital is a smaller business development company (BDC) that’s been public since 2012 and has “only” $380 million of assets (mostly in the form of loans to 39 middle market companies). But it has a unique business model that keeps costs low, which we think makes this baby bond attractive.

The special sauce here is that, except for these bonds, most of OFS’ liabilities are debentures from the U.S. Small Business Administration (SBA), which are advantaged, low interest rate loans—specifically carrying an average fixed-rate of just 3.18%!

While these SBA loans don’t count toward the leverage limitations, the payoff is well worth it because the costs are so tame. In the first quarter, OFS had $9 million of investment income, but its interest expense totaled just $1.6 million—a very healthy 5.6 times coverage ratio.

Moreover, OFS now has no debt maturities (SBA, these bonds or otherwise) that mature before 2022, so there’s basically no chance of the firm getting squeezed even if there was a general credit crunch. Digging deeper, we see that more than three-quarters of OFS Capital’s loans are both senior and floating, so income should rise with interest rates.

We’d prefer that OFS Capital was a big larger, but all in all, the low-cost of its debt, lack of debt maturities and large coverage ratio of income-to-interest-expense means these notes should do just fine.

AGNC Investment Series N Fixed-to-Floating Preferred Shares (AGNCN at most brokerages)

Coupon: 7.00% fixed annually ($0.4375 per share, per quarter) through 10/15/22; rate will then float at 5.11% plus three-month LIBOR

Dividends Payable: 15th 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: 10/15/2022

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 have seen their book values (and common stock prices) decrease in recent years as 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 if the environment turns bearish.

AGNC Investment’s fixed-to-floating preferred stock takes safety to a ridiculous level, which is why we think it’s a good investment. AGNC is currently paying out just $9 million or so of preferred dividends every quarter, compared to around $210 million of dividends on its common stock!

Moreover, the company’s book value (basically the value of its investments in mortgage-backed securities, less repurchase agreements and other liabilities) was a whopping $8.3 billion at the end of March 2018, making it one of the larger mortgage REITs in the industry, and dwarfing the $500 million of par value in preferred stock outstanding. Said another way, after paying off all of its liabilities, AGNC could buy back all of its preferred stock 16 times over.

Given the cushion, AGNC Investment would basically have to blow up for the preferred investor not to get paid, and given the company’s size and solid history (it’s been public since May 2008 and has navigated many market environments well) that is extraordinarily unlikely.

As I wrote above, while AGNCN doesn’t have a maturity date, it does have a floating feature that should protect the preferred from falling much if interest rates rise. It will pay out at a 7% rate no matter what through October 2022, but after that, the preferred’s payment will be 5.11% plus three-month LIBOR, which tends to move up and down with the Federal Reserve’s action. At the end of April, three-month LIBOR was 2.35%, and will head higher if the Fed continues to tighten.

Knowing that the payment will (eventually) float should keep investors from bailing out should interest rates rise, because they know their payments will increase down the road. The combination of the fixed-to-floating feature and the extreme amount of cushion presented by AGNC makes this a very attractive instrument to own going forward.

The Bottom Line

Whether you’re interested in any of these three 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.

Chloe Lutts Jensen, Chief Analyst, Cabot Dividend Investor

Retired or Thinking About Retirement?

Chloe Lutts Jensen developed Cabot's proprietary Individualized Retirement Income System (IRIS) and Cabot Dividend Investor to provide both high income and peace of mind. If you’re retired or thinking about retirement, her advisory is designed for you.

 

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

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