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High-Yielding Fixed-Rate Favorites

In the near-zero interest environment, most investors don’t believe safe, steady gains are possible. But they are.

Ever since late 2008, income investors have been in a pickle — with the Fed holding rates near 0% (and money market funds yielding about the same), these investors have been forced into dividend stocks to earn their 3% or 4% yields, explains Mike Cintolo, editor of Cabot Growth Investor.

We have nothing against dividend stocks, but some investors are also looking for some surety through fixed-rate bonds—getting 5% to 7% interest every year (hopefully more if possible) 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. But they are.

We focus on two plentiful, popular types of fixed-income securities—term preferred stocks and fixed-rate “baby” bonds. (They’re called “baby” bonds because the issue size is somewhat small compared to huge private placements by blue-chip companies.)

As with any investment, you have to know what to look for, but once you do, you can achieve the steady and safe income stream you desire.

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.

Here are three to consider, but a word to the wise—nothing is risk-free, including these term preferreds and baby bonds. (If it was, you’d be getting 0.1% 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.

Here are the three best fixed-income bonds right now.

Prospect Capital Fixed-Rate Bonds

Coupon: 6.25%

Interest Payable: 15th of March, June, September and December

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

Callable as of: 12/15/2018

Maturity Date: 6/15/2024

Prospect Capital is a huge BDC, with a whopping $6.2 billion of assets at year-end, mostly via debt investments in various small companies.

It’s been public since 2004 and has paid a common dividend every month since coming public.

Interestingly, Prospect’s common stock has come under fire occasionally for a variety of reasons, including a dividend cut a couple of years ago. But as an investor in the baby bonds, we don’t really care. What we care about is Prospect’s ability to pay interest (and, eventually, principle) on its bonds.

As mentioned above, as a BDC, Prospect is subject to the asset coverage restriction, and we see that here—the firm’s liabilities total $2.7 billion, so assets are about 2.26 times the total liabilities, providing lots of cushion for the baby bonds.

Moreover, the firm’s income over the past six months was 4.4 times as large as its interest obligations—again, lots of cushion for owners of the bonds.

Moreover, PBB isn’t callable until the end of 2018, and unless interest rates tumble sharply in the years ahead, we doubt they’ll be called for many years.

Gladstone Investment Fixed-Rate Term Preferred Stock

Coupon: 6.50%

Interest Payable: Last Day of Every month

(Note: Ex-dividend dates are around the 17th of each month)

Callable as of: 5/31/2018

Maturity Date: 5/31/2022

Gladstone Investment is also a BDC, but it’s a small outfit compared to Prospect—it has “only” $486 million in assets, and again, much of that (74%) is debt investments in smaller companies, though the rest is via equity investments in those same firms (either directly, or via warrants or preferred stock).

While it’s smaller, Gladstone Investment is diversified, with investments in 35 companies in 18 different industries; 19% of its assets are in home and office furnishings, its largest sector stake.

What’s impressive to us from a safety point of view is that, like Prospect, this BDC came public more than 10 years ago (2005 to be exact) and has paid 138 consecutive monthly common dividends, even through the Great Recession.

Plus, of course, they’re subject to the asset coverage requirement — Gladstone Investment’s assets are about 2.57 times its total liabilities.

As for income, the firm’s total income is about 4.0 times the combination of its interest payments and dividends paid on its term preferred stock.

And, for what it’s worth, the common dividend alone is nearly twice as large (dollar-wise) as the interest and term preferred payments. Plenty of cushion there.

Note the nearest call date (mid-2018) and the maturity date (mid-2022) are a bit earlier than Prospect’s bonds, so factor that into the price you want to pay.

Eagle Point Credit Term Preferred Stock

Coupon: 7.75%

Interest Payable: Last Day of Every month

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

Callable as of: 10/29/2021

Maturity Date: 10/30/2026

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, and with lots of leverage, too. Thus, Eagle Point itself is almost like a juiced up high-yield bond fund.

Indeed, when high-yield bonds were under duress during the long the 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’s since recovered strongly to the north of $17.50 per share.)

However, as investors in the fund’s term preferred stock, that action doesn’t mean much. What counts is the fund’s asset coverage ratio and the cash its investments are spinning off.

As I mentioned above, for closed-end funds, assets must be at least two times the total leverage (debt plus preferred stock) issued.

Eagle Point is even more conservative on that front; the funds’ assets total about $448 million at year-end, compared to just $150 million of total leverage (including $60 million of fixed-rate bonds, and $90 million of its preferred stock)—about three times as many assets as liabilities.

As for income, Eagle Point brought in about $56 million of income in 2016, compared to interest obligations on its debt and preferred stock of about $11 million—a ratio of 5-to-1.

Of course, there’s nothing that says Eagle Point can’t increase its leverage going forward, but clearly, there’s plenty of cushion here, which spells safety.

Even better, this series of preferred stock just came public last year, and while it has a slightly longer time until maturity (2026), it’s also not callable for a few years (2021), so you don’t have to worry about it getting called away after just a few quarters.

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.

Mike Cintolo is vice president of investments and chief analyst of Cabot Heritage Corporation.

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