Here at High Dividend Opportunities we love to noodle on retirement and income investing. It's why we write about it, live it, and talk about it all the time.
You don't tire talking about what you love.
So as we noodle, write, talk, and live, we have created our Income Method. A unique variation of immediate income investing and value investing. Some may scorn it as "not unique" or "not original" but those same people provide nothing to the Seeking Alpha community as a whole. So I encourage trolls to return to their bridge, someone might be crossing it!
As for the rest of us, we have business at hand. Many of you, either as your retirement began or as you are planning for retirement, had a well-meaning stranger, advisor, or salesperson pitch the idea of an annuity being perfect for you.
What's an Annuity?
An annuity is a retirement product that's sold mostly by large life insurance firms via registered investment advisors. You in essence give them your hard-earned dollars, and they pay you back a set amount each month until you die, or you and your spouse depending on the type of annuity you buy.
Often the return on annuities is extremely low due to it being in essence guaranteed funds. You never have to worry about outliving your savings so long as the insurance company offering the product remains standing. Even if your payouts total to more than your original capital and any interest it has earned, you keep getting them.
Insurance companies, especially life insurance companies, have a good handle on how long you are expected to live and set your payouts accordingly. Few ever live beyond their initial investment payments and accrued interest. If you die before you've drained all your capital, often a lump sum is provided to your beneficiary. The insurance companies make a much higher return off of your money than they provide to you, just like a bank does with your deposits.
The ultimate trade off built into annuities is the guaranteed income for life vs. higher levels of income. Your money spent on the annuity is locked in and unrecoverable during your lifetime, but also gone is the worry about outliving your savings.
What's a Baby Bond?
Baby bonds are the little brother to traditional bonds. They carry many of the same benefits: Taxed as interest, must be paid or the company goes into default, higher up the capital stack, and lower risk. They however remove many of the drawbacks: Low fees for buying them, they do not trade with a separate interest payment component when buying between payments. Importantly, they are much easier to buy as they are listed on stock exchanges. In fact, they trade on the stock exchanges rather than on the bond exchanges. All you have to do is find the ticker symbol and input it into the box where you usually put an order to buy a stock.
In essence, buying a baby bond is becoming a creditor for a large company. They have issued out the bond which offers a set annual yield and maturity date. Many also have an optional call date where the company can buy back the bonds at par value before they mature.
Baby bonds are offered by a large array of firms providing a higher level of options and risk levels than annuities.
More About Baby Bonds
Most baby bonds make interest payments on a quarterly basis. This is a big plus because regular bonds usually pay only twice a year (semi annually).
Most of the issues have a $25.00 par value, and become callable usually five years from the date of issue, at $25.00/share plus accrued interest.
Debt issues, including baby bonds, tend to have low price volatility and can normally be sold anytime.
Distributions paid by these debt securities are considered "interest income" for tax purposes and as such are not eligible for the preferential 15% to 20% tax rate on dividends. This is similar to regular bonds.
Most baby bonds pay a higher interest rate than their regular bond counterparts (for the same type of risk) because institutional investors do not buy them and many retail investors are not aware they exist.
During periods of price volatility, baby bonds with a short maturity become attractive to investors because they carry little "interest rate risk."
A Comparison of Annuities and Baby Bonds
Now we will take a few minutes to look at various aspects and how they stack up to one another.
Availability of Choices
Annuities not only come in an array of types but also from various firms. In the end, most annuities are extremely low risk, but the more complex of an annuity it is, the more the person pitching you the idea gets as a kickback. Boring, old original annuities are the easiest to understand and have fewer bells and whistles. In the end, however, annuities from each firm will largely be identical in make-up and style.
Baby bonds come in more shapes and sizes. Baby bonds will have varying maturity dates, interest yields, and even payment cycles. You can split your capital between them to effectively generate the yield and payment cycle you prefer. The base roots of a baby bond will be identical between issuers, but the interest coverage and capital coverage of the firm will vary greatly. In the end, baby bonds come in a larger degree of choices but there's also room for more risk with them.
Ability to Get Out When Needed
The ability to cash in your chips and leave when needed is extremely important to many people. Annuities provide limited means to remove your capital from them. In essence, you're purchasing an insurance product and you own that contractual agreement – your cash is locked in.
With baby bonds, you own individual bonds with a face value, usually $25, and you can buy more, sell all, or sell some at your discretion. So if a major life event comes your way, you can cash out some of your bond holdings and take care of business. You're out of luck with an annuity in those dire moments of need.
Safety First, My Momma Always Said
The key tenant of many investors is capital preservation. We have expounded multiple times on why we feel this is a misfocus. We prefer to focus on income preservation.
When it comes to either one, annuities can be hard to beat. If the cash you're using to buy the annuity is not earning any yield currently, then the annuity locks in a guaranteed yield for life as long as the issuing firm does not collapse.
Baby bonds do not have the same level of guarantee. While you can buy baby bonds from extremely low-risk companies and never have a moment of risk to their ability to pay you or give you your capital back at maturity, you also can buy baby bonds from nearly broke firms and roll the dice. Careful income investors will strategically buy baby bonds to build the foundation of their income portfolio to generate long-term reliable income.
Both baby bonds and annuities can be viewed as "set and forget" investments. However when your baby bond matures you will need to shuffle those funds around into another choice to keep your income flowing. This is not necessary with an annuity.
When planning your retirement income stream, your level of risk tolerance and needed income stream will help eliminate choices. Baby bonds and Annuities are both lower-risk investments.
Extremely Reliable Income
No Return of original capital when closed unless due to untimely death
Return of original capital when bond matures or is called. Also capital gains opportunity if bond is purchased below PAR.
Taxed as ordinary income
Taxed as interest income
Locked in, unable to sell in event of emergency
You can reduce or add to position over time as needed
Very low yields, payments are mostly return of your original capital
Higher yields due to shorter term maturity timeframe and lack of institutional investment in baby bonds.
Only retirees with the largest saving balances for retirement will benefit from this product
Retirees with any sized retirement saving can see superior income generation from these options.
While baby bonds are excellent, they are not the only route to get exposure to fixed income. We at High Dividend Opportunities prefer to invest our capital in baby bonds, preferred stocks and high dividend stocks. We are recommending a 45% allocation to baby bonds, preferred stocks and similar investments. The related income stream provides investors with a great level of cash flows. You can re-invest your dividends and interest to grow your future income or use it as spending money. While this does require a higher level of due diligence and watch-care, we know that life events rarely would allow us to outlive the extremely low yields and payouts from annuities. On average our baby bond picks yield 6.6% – well above the sub-2% yields on many annuity products. In fact, annuities in this kind of environment will likely barely match long-term inflation, and therefore you could be losing money with yields close to 2%. We believe that having a highly-diversified portfolio of stocks, baby bonds and preferred stocks is the best way to protect and grow your hard earned savings.