The Best Fixed-Rate Bonds to Buy Now Plus: The Pros and Cons of DRIP Plans, and Income Investing in Retirement

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 back to square one, slashing short-term interest rates back to near zero thanks to the coronavirus impact on the U.S. economy, forcing investors to dive into dividend stocks to earn their 3% or 4% yields.

But many investors are also looking for some surety through fixed-rate bonds—getting 5% to 7% interest every year (sometimes more) with a lot of safety is especially attractive when longer-term government bonds are yielding less than 2%. In a low-interest 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.

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 stream 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, even if rates continue to 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 3 Best Fixed-Rate Bonds Right Now

So what term preferreds, fixed-rated baby bonds and fixed-to-floating preferreds are our favorites? Here are three 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 three 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, 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 firm is having another pretty big drawdown in its net asset value in recent quarters—it’s fallen to around $10 per share from $14 a few months ago!

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 $520 million, compared to $101 million of fixed-rate bonds (asset coverage of more than five-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 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 2019, for instance, Eagle Point brought in $51.7 million of investment income, but it had interest obligations on its bonds of just $5.1 million or so—10-to-1 coverage!

ECCX has a slightly longer time until maturity (2027) than we’d prefer, and it’s callable in April 2021, which is a bit sooner given that it generally trades above par. 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%), we don’t think it’s likely to be called even after April 2021.

Best Fixed-Rate Bond #2: Monroe Capital Baby Bond (MRCCL)

Coupon: 5.75% ($0.359 per share, per quarter)

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: 10/31/2020

Maturity Date: 10/31/2023

OK, OK, 5.75% 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.

Monroe Capital (common stock ticker is MRCC) is a mid-sized business development company (BDC) that’s been public since 2012 and has $693 million of assets in the form more than 150 total loans and a couple dozen equity positions in more than 80 different companies.

To be fair, the firm is levered up a bit more than most of its peers; at the end of the most recent quarter had $440 million of debt, giving it an asset coverage ratio of “only” 1.6x or so.

However, much of that debt consists of debentures from the U.S. Small Business Administration (SBA), which are advantaged, low interest rate loans. Indeed, in the most recent quarter, Monroe’s interest income was $17.3 million, compared to interest payments due of just $5.5 million—plenty of leeway there.

But there are two other factors that make MRCCL a good bet. First, Monroe itself is a conservative lender—a full 77% of its loans are first-lien, and as mentioned earlier, it’s very diversified, with its largest single investment less than 4% of assets.

Just as important is the structure of Monroe’s liabilities—it doesn’t have any debt maturing before 2023, so there’s basically no chance of the firm getting squeezed.

All told, we think MRCCL is a solid, conservative issue for those willing to collect some interest in the years ahead. There’s a bit of call risk coming up (October 30, 2020), but given the already-low coupon, we think it’s more like MRCCL remains outstanding until maturity.

Best Fixed-Rate Bond #3: 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 (though the latter isn’t much of a threat at the moment).

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 ($129 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 $36 million or so of preferred dividends every quarter (it has many series of preferreds, but the I is our current favorite), while dividends on its common stock total $360 million, 10 times as much!

Moreover, the company’s book value (basically the value of its investments in mortgage-backed securities, less repurchase agreements and other liabilities) stands at a whopping $15.2 billion, making it the largest mortgage REIT in the industry, and dwarfing the $2 billion 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 in whole nearly eight times over.

Given the cushion, Annaly Capital 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 1997 and has navigated many market environments well) that is extraordinarily unlikely.

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, but 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.

Knowing that the payment will (eventually) float should keep investors from bailing out should interest rates rise again after the coronavirus clouds have cleared, 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 Annaly 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.

Now, if you’d prefer dividends…

The Pros and Cons of DRIP Plans

Dividend reinvestment is one of the most powerful weapons in the income investor’s toolbox. You’ve probably heard it said that compound interest is the most powerful force in the universe (a quote attributed to Einstein, almost certainly erroneously), and Dividend Reinvestment Plans (i.e. DRIPs, or DRIP plans, as many redundantly refer to them) take advantage of some of the same forces—namely time and compounding.

When you choose to reinvest your dividends, each stock’s dividend payment is used to buy new shares of that same stock, at the market rate. You then start earning dividends on those new shares, and those dividends get turned into more shares, and so on and so forth. Over time, the number of shares you own and the size of the dividend checks you receive every quarter will both gradually increase, without you doing a thing.

The Benefits of a DRIP

Most brokers will reinvest your dividends for you for free, and the purchases will be completed without fees (although you will owe income taxes on the dividend amount). Alternatively, you can often sign up for a Dividend Reinvestment Plan, or DRIP, directly with the dividend-paying company. Company-operated DRIP plans allow investors to buy shares directly from the company, and in exchange, dividends are automatically reinvested in the company’s stock, sometimes at below-market prices.

Those are the two most obvious benefits of dividend reinvesting: You can increase your position for free, without fees, and it’s automatic, so you don’t have to think about it. If a stock is high quality and you plan to own it for a long time, dividend reinvestment is a great passive way to increase your exposure over time. Sure, you could collect the dividends and then manually invest them in something else, but a good habit that takes no effort is easier to keep up than one that takes a little effort.

However, the third big reason to reinvest dividends, and the less obvious one, is actually the most powerful. It’s the power of compounding, the same action that makes compound interest so powerful.

When you reinvest dividends, you increase the size of your investment, thus also increasing the dividends you’ll receive next time. So each reinvestment will be slightly larger than the last (assuming dividend payments don’t decrease). Just as with compound interest, you’ll be surprised how quickly those little additions can add up!

For example, let’s say you own 100 shares of a $40 stock with a 2.5% yield. That means the company pays $1.00 per share in dividends each year, or 25 cents per quarter. This table shows how your dividend income and the size of your investment will change over the first year.

As you can see, reinvesting that first $25 increases your second dividend payment by 16 cents, because you now own another $25 worth of dividend-paying stock. By the end of the year, your quarterly dividends have increased to $25.47, and the value of your investment has increased by $100.94—that $100 is simply the dividend payments, which you would have earned whether or not you chose to reinvest. But the extra 94 cents is “dividends on dividends,” which you earned thanks to reinvesting.

Ninety-four cents may not seem like a lot, which is why the second important force at work here is time. After 10 years, your annual dividend income from this same position will be $126.31, up from $100.94 the first year. (That’s a yield on cost of 3.16%, based on your initial investment.) The value of your investment will be $5,132.11, without any appreciation in the stock price. One-hundred thirty-two dollars and eleven cents of that is thanks to your dividends on dividends. (If you hadn’t reinvested, the value of your investment would still be $4,000, and you would have collected $1,000 in dividends, for a total return of $5,000. The difference between that and $5,132.11 is what we’re calling dividends on dividends.)

After 30 years, your investment will be worth $8,448.26, and you’ll be earning $207.95 per year in dividends—you’ve more than doubled your original income, and are earning a yield on cost of 5.2%.

And that’s all without a single increase in the stock price, or the dividend. If you buy a Dividend Aristocrat that increases its dividend every year, your returns improve at every step. If the company in the example above increases its dividend by 5% per year, your annual income will reach $200 at the end of 10 years, instead of 30. After 30 years, your annual income will be a whopping $2,218.83, and your investment will be worth $22,022.24. Not bad for a stock that doesn’t go up!

Of course, if you buy a stock that does goes up over 30 years (as most of them do!) you’ll be even happier. While your reinvestments will occur at higher prices, the capital appreciation on those new shares more than makes up for it. (If you’re intrigued, search for a dividend reinvestment calculator online and punch in some real numbers.)

The Case Against DRIPs

While dividend reinvestment is powerful, there are a couple reasons why you might not want to reinvest your dividends.

The most obvious reason is that you need the income. If you’re in the “distribution” phase of your investing life, dividends are a perfect source of passive income. Income from qualified dividends is taxed at the long-term capital gains rate (currently 15% for investors who are in the 25% to 35% tax bracket for ordinary income, 0% for taxpayers in a lower bracket and 20% for those in the highest bracket). So if you’re going to be looking to your portfolio for income every month anyway, it makes sense to have that cash deposited in your account.

You might also choose to stop reinvesting your dividends for allocation reasons. Reinvesting your dividends, through DRIP plans or otherwise, will cause your stock positions to grow over time, and if you’ve owned a particular issue for a long time, it may already be a large enough percentage of your portfolio. Higher-yielding positions will grow faster, which can throw your allocations out of whack pretty quickly. So once a stock position is as big as you want it to get (for now) feel free to turn off dividend reinvestment for that position, and either enjoy the extra income or save up the cash to invest in other stocks.

Finally, you may also have stock-specific reasons not to reinvest dividends—if a stock is temporarily overvalued, or you simply don’t want to buy any more of it at current prices.

But bottom line, reinvesting dividends through a broker or by signing up for DRIP plans directly through the dividend-paying companies, is a surprisingly powerful tool to passively improve your investment returns, as long as it fits with your investing goals.

Income Investing in Retirement

If you’ve been investing for a long time already, you’ve probably pursued capital appreciation as your primary goal. That means buying investments that you believe will go up in price, then selling at some point, once your initial investment has increased in value. However, fixed-rate bonds, preferred stocks and DRIPs, like the ones we’ve discussed in this report, have different goals. As a result, those types of investments are popular among retirees.

Don’t get me wrong: capital appreciation is still important for retirees, but most will also have a new goal: income. You may have used an investment account to save and earn money for a big purchase in the past, like a house or a college education. Once you had enough—or it was time to send your kids to college— you withdrew a big chunk of money. But most of the time, investing when you’re still earning is more about making money than taking money out.

In retirement, you still want to be making money, but you’re also probably going to want to cash in some of your investments to pay for things. That can mean selling a chunk of stock so you can afford a luxury cruise, or just withdrawing a little bit every month to pay the bills. Or both.

For investors who’ve spent all their lives adding to their nest egg every month, helping it grow by carefully choosing the best investments, it can be stressful, disorienting and even a little scary to suddenly start doing the opposite. Even with the money there, you might not be sure how much you can use, and that might keep you from going on that cruise, or make you anxious about paying your bills every month.

Especially if you’ve invested for a long time, and are used to having capital appreciation as your No. 1 goal, actually using the money you’re earning can be difficult to reconcile with your investing strategy.

To take some of the mystery out of retirement investing, a retirement spending calculator can be a useful tool.

Many advisors think these calculators have more weaknesses than strengths, and I won’t argue. Most use an average annual return on investment to calculate investment returns, which can create unrealistic projections. They also assume that you can roughly estimate your annual spending for the next 30-plus years. But even using generous assumptions, it’s hard to account for unanticipated expenses, like medical bills. It also oversimplifies retirees’ spending habits—many retirees can and do adjust their spending when their circumstances change, which the calculators don’t account for.

But despite their drawbacks, running some numbers through one of these calculators can give you a good starting point for deeper planning.

If you’ve already used one of these calculators, feel free to plug in those numbers in this exercise. If not, the retirement calculator below accounts for more variables than most, including “modern” retirements where you’re still earning some income.

Some of these numbers are almost guaranteed to change, but filling out the worksheet will give you a starting place for your income investing.

I hope this report has been informative and educational—and you’ve learned how income investing can enhance your portfolio and create wealth that can last for years!

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