A Forgotten Investment Worth Considering: Exchange-Traded Bonds

A long-term senior bond from eBay is listed on the New York Stock Exchange. PHOTO: BECK DIEFENBACH/REUTERS

With most Treasurys yielding under 2% and savings accounts yielding even less, individual investors are hard-pressed to figure out what to do with money they don’t want exposed to material market risk. One viable alternative is bonds that trade on stock exchanges, known as exchange-traded bonds. About $19 billion of these securities trade mostly on the New York Stock Exchange, with many investment-grade offerings generally yielding between 5% and 6%. While tiny compared with the traditional $9.3 trillion corporate- bond market, exchange-traded bonds generally offer more transparency than traditional debt offerings. That’s because investors who buy them have the same ease of access to bid and ask information, current yield and limit orders they enjoy when buying and selling stocks, says Kevin Conery, fixed-income trading desk analyst at Piper Jaffrey. Exchange-traded bonds also have other features that individual investors might find attractive. These securities are issued in $25 bonds, compared with $1,000 for traditional corporate bonds. They pay interest on a quarterly basis versus corporate issues that pay semiannually. And because issuers can typically call exchange-traded bonds five years after their initial offering at par and any point thereafter, the yields are often higher than traditional corporate bonds issued by the same company. Companies are willing to offer higher yields on exchange-traded bonds because the five-year call features gives them more flexibility to refinance debt if rates fall or eliminate it altogether if the money is no longer needed—something that $1,000 corporates can only do closer to maturity, if at all. That five-year call feature also can reduce the overall volatility of these bonds (as long as they aren’t suffering from credit issues), especially after the call date has passed. The reason: Prices tend to trade close to par within a year or two of the call and anytime thereafter. Consider the long-term senior bond of internet-auction giant eBay Inc., (EBAY) which is listed on the NYSE under the symbol EBAYL. This investment-grade offering currently yields 5.59% and is trading at $27.

And Lowe’s is taking steps to improve pricing and promotional tools in order to recoup lost margins in the new year. Moreover, lower interest rates, stability in the housing sector and advertising efficiencies from the continued shift to digital marketing should give the stock a boost. All three stocks are rated buy at UBS, with Hasbro upgraded on Nov. 25. Amazon has a $2,100 price target, Hasbro has a $117 price target and Lowe’s price target is $140. Home improvement retailer Lowe’s is also a “top global idea” at RBC Capital Markets, where it’s rated outperform with a $134 price target. “While we have long believed that part of Lowe’s relative underperformance versus Home Depot relates to their respective store bases, as Lowe’s stores tend to be located further out from major metro areas, we have also underestimated how difficult Lowe’s had made it for Pros customers to do business with the company, and improvements on this front should enable it to gain incremental market share,” analyst Scot Ciccarelli wrote in a note.

Young consumers are increasingly concerned about climate change which makes environmental sustainability a top issue for the retail sector. “We believe brands that promote sustainability will gain wallet share of younger consumers and become more relevant,” wrote Cowen analysts in their “Future of Retail” report. “In our view, there is a strong momentum toward eliminating waste among retailers.”

Cyber Monday mobile transactions in 2019 totaled $3.1 billion, according to Adobe Analytics data. Total Cyber Monday online sales were $9.4 billion, a record. “The smartphone continues to radically alter the end-to-end customer experience as customers increasingly rely on smartphones to research, transact and engage with brands,” Cowen analysts say. The rise of smartphone shopping is due to social media platforms and the influencers, brand ambassadors, and communities that have popped up on them. Cowen data shows that more than 63% of millennials ages 18 to 34 spend at least four hours per day on their mobile phones. “We also believe that the channel has major implications for both in-store traffic and conversion as consumers use devices to inform purchases before or during shopping trips, including the use of smart labels, virtual reality and augmented reality,” Cowen said. Even as shoppers use mobile devices and other e-commerce platforms to make a purchase, customers are increasingly opting to make the last-mile trek for their items themselves. “We expect more shoppers to adopt and appreciate curbside pickup, which we view as an ideal manifestation of combining physical and digital retail,” Cowen said.

Cowen data shows that 21% of the U.S. population has tried curbside pickup or buy-online-pickup-in-store for their groceries. Walmart Inc. (WMT) and Target Corp. (TGT) are the leaders in curbside pickup, Cowen says. Both are able to leverage their large store fleets to offer the service. “Given that the same-day options rely on our store assets, team and inventory they are much more profitable than traditional e-commerce fulfillment,” said Target’s Chief Executive Brian Cornell on the third-quarter earnings call. E-commerce on various devices and convenient fulfillment methods are also erasing the shopping calendar. “Black Friday will change dramatically in 2020,” said Graham Cooke, chief executive of Qubit, a personalization software provider. “There’s no need to wake up at the crack of dawn just to fight over sale items when shoppers can find great deals from their couch.”

Moody’s analysts think global trade policy disputes, will continue to be a risk factor in 2020, as well as a weight on consumer confidence. President Trump’s U.S. - China trade war has disrupted global manufacturing and retailing supply lines and the import tariffs have raised some prices. “Although we do not expect a recession in 2020, recession risks are high amid a backdrop of trade policy uncertainty, [and] an unpredictable political and geopolitical environment,” Moody’s says. “Increased trade friction could trigger spikes of volatility in financial markets and further disrupt trade flows. Many companies have so far been able to lessen the effect of tariffs through a combination of cost reductions, buildup of pre-tariff inventory and price increases within the industry supply chain. But these offsets may not last if these tensions persist.” Moody’s forecasts slight operating income growth to a 3% or 4% increase in 2020 for the retails sector, though analysts don’t expect “much improvement” in operating margins as retailers use promotions to increase market share. Dollar stores like Dollar General Inc. (DG), off-price retailers like TJX Cos. (TJX), and supermarkets like Kroger Co. (KR) are expected to outperform. Department stores like Macy’s Inc. (M) and J.C. Penney Co. Inc. (JCP), and drug stores like Walgreens Boots Alliance Inc. (WBA) are forecast to underperform. The Amplify Online Retail ETF (IBUY) is up 30% for the past year, the SPDR S&P Retail ETF (XRT) has gained 13.4% for the period, and the Dow Jones Industrial Average (.DJI), and S&P 500 index (.SPX) are up 24.2% and 30.3% respectively.

Secondhand retailers are also in a position to benefit from concern about sustainability. Cowen thinks RealReal Inc. (REAL) and ThredUp, which forecasts that the secondhand market will be valued at $51 billion by 2023, have an advantage. Nearly half of the total sustainable merchandise is for women, 25% for children, and 24% for men, according to the StyleSage Sustainability Report.

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Some caveats

Barry McAlinden, a fixed-income strategist at UBS Global Wealth Management, cautions investors not to mistake the ease of buying exchange-traded bonds with reduced need for due diligence. “While their returns and ostensible safety can be enticing,” says Mr. McAlinden, “there are many variables that need to be considered before investing and special caveats that may come into play during difficult times.” Among the things investors need to consider: Bond interest is taxed as ordinary income. For higher-income households, this is going to be a much higher rate than the up-to-20% rate at which qualified dividends from common and preferred stock dividends are taxed. As such, tax-deferred retirement accounts might be an ideal place to hold these bonds.

Still, the hunt for yield is leading some investors to take on principal risk. The municipal-bond insurer Assured Guaranty Municipal Holdings (AGO-B) ultralong-term exchange-traded bond is trading at $27.50 and can be called anytime with 20 days’ notice. While the current yield of 6.36% looks enticing, a call at this price would result in a 10% capital loss. To break even, new investors would need the bond to remain outstanding for at least a year and a half. Because the aforementioned eBay bond trades well above par, its effective annualized yield would be reduced to 1.81% if the company calls the security a year from now—its initial call date (see table.) Effective yield will rise the longer the bond remains outstanding as investors receive more quarterly payments. Maturity dates also are important, especially if that date stretches into the next century. The longer the maturity date, the more volatile pricing can be, especially when interest rates move. Pricing is based on yield and credit spreads over equivalently termed Treasurys. Not all exchange-traded bonds are rated. That could mean the company is confident that its issue will be well subscribed to without a rating, but it also could indicate a company that doesn’t want to pay for a mediocre grade. Quantumonline.com maintains a free database to help investors get started understanding the exchange-traded bond market.

Maturity rates

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By comparison, a traditional 4% coupon bond from eBay that matures in 2042 trades at 99.54 (or $995.40 per bond) and yields 4.14%. And while individuals can make any size purchase of exchange-traded bonds, there is a minimum online bid of 10 corporate bonds, or $9,954. With many online major brokerages having eliminated trading fees, exchange-traded bonds can be bought and sold without cost. However, because these bonds are thinly traded, investors need to use limit orders to ensure efficient pricing.

Some of these securities are junior subordinated debt, meaning they have a lower-priority claim against assets if a company goes into bankruptcy. While senior bonds can’t miss payments without triggering a default, junior subordinated debt can typically defer interest payments for up to 10 years without doing so. That said, such deferrals are rare. As UBS’s Mr. McAlinden explains, “Such a deferral would wreck any firms’ plans to access capital markets going forward.” If investors are hoping to benefit from the bond rally—due to additional interest-rate cuts—they shouldn’t count on it. Piper Jaffrey’s Mr. Conery explains such a price rise is only likely if there is at least 3.5 years before the bond is callable. “Prices of bonds with shorter call dates will likely trade closer to their call price,” says Mr. Conery, regardless of minor changes in interest rates.