Published December 19, 2013
Corporate retail notes are an attractive option for individual investors but generally provide lower returns than mainstream corporate bonds, according to a new study from the School of Management.
Published in the most recent Journal of Fixed Income, the study says that individual investors face two important obstacles when investing in corporate bonds: availability and trading costs.
Retail notes, a debt security issued directly to individuals through brokers in small denominations, typically on a weekly basis, have proven to be a popular solution to these obstacles. The notes also trade over the counter; however, trading is very thin.
“Retail notes are designed for easy purchase by individual investors,” says study co-author Joseph Ogden, professor of finance and managerial economics. “But they tend to be overpriced at the start, primarily because most are callable at par value with short deferment periods. That means the corporation you bought the note from can buy it back before it’s fully mature, relatively soon after it was issued — and you lose out on interest.”
The study analyzed the pricing and performance of 1,775 retail notes issued by industrial firms from 2005 to 2009, comparing their offering yields and prices, as well as returns, to benchmark indexes of mainstream corporate bonds matched on rating and maturity.
Results showed that yields on new callable retail notes do not typically contain a call premium, that average returns are lower for callable notes than for non-callable notes, and that the majority of callable notes are called shortly after the deferment period expires.
Ogden says there are a few reasons that the notes have been popular despite their low performance.
“Individual investors may be willing to accept lower yields and returns on new retail notes because they tend to be more readily available than mainstream bonds,” says Ogden, “and because the notes allow investors to avoid the trading costs on mainstream corporate bonds, which is important in the current low interest rate environment.
“Additionally, some investors may place a high personal value on the ‘death put’ provision — an option included in all retail notes that allows the investor’s estate to sell the bond back at par value if the investor dies.”
Ogden collaborated on the study with Igor Kozhanov, financial economist in the Division of Economic and Risk Analysis at the U.S. Securities and Exchange Commission.