Corporate Debt Goes Retail

Until a few years ago, if you wanted to put your client into corporate bonds, the only way to do that was to invest in bond funds. The trouble with bond funds is, you don't know what the exact yield is going to be, the coupon payment or the maturity they will offer. For that, you need to buy individual bonds. And that used to be difficult. Sure, you could find the odd corporate bond in the secondary market, but your client had to pony up tens of thousands of dollars. You couldn't get them at par, and, in fact, you would have had to pay a marked up price. Diversification? Forget it, unless the client could afford to buy several different issues.

But now, thanks to a new product called retail notes, brokers can access investment grade corporate debt for their clients in $1,000 increments. All the different pieces that go into retail notes add up to an excellent product for income-desiring individuals. Top of the heap credit quality, small increments, comparatively higher yields and even a death call make it easy, for the first time, for the average investor to buy individual corporate bonds. And they can only buy them through brokers.

“Retail notes have changed the way I buy and sell bonds for my clients,” says Jim Woodson, a broker at Bernardo First Securities who also writes The Yield Report, a weekly newsletter about retail notes. “They're simple, and they often offer rates that you can't find elsewhere.”

In fact, the yields are quite a bit more attractive than other income-producing investments. Recently the average yield on 10-year corporate bonds was at 4.67 percent, according to Bloomberg. A similarly timed retail note for DaimlerChrysler had a coupon of 5.90 percent. An even more enticing spread is the 15-year PHH bond, callable in three years with a coupon of 7.95 percent. Compare that to the five-year government note whose coupon is 3.98 percent. “And investors don't have to take on all that much more risk to get those yields,” Jim Schaberg, managing director of Incapital, a Chicago-based investment bank that issues retail notes under the brand name InterNotes.

Born in the late 1990s, retail notes have reached critical mass, with $71 billion worth of bonds issued, according to Schaberg. More issuers are joining all the time. Last November, for example, Boeing and GE Capital launched retail note issues, bringing almost all the top 10 issuers of corporate bonds into the retail arena. Now investors have dozens of bonds to choose from every week. Indeed, retail notes have practically become an asset class in their own right; their popularity is exploding among individuals and brokers. “It's a product whose time has finally arrived,” says Jonathan Eklund, a broker at RBC Dain Rauscher in Chicago. “It was a great idea, but now you have the volume and the diversity of offerings to find almost any bond for any portfolio's need.”

The first retail notes were issued by GMAC, the credit arm of car giant General Motors, in 1996. The financial press hailed the issue as a revolution in bonds. Finally, the individual bond investor had an option that was simple, straightforward and useful. Individuals now had a chance to buy bonds at par price with guaranteed redemption options. Nevertheless the issue only sold $300 million worth of bonds in its first year — a minuscule portion of the overall corporate bond market — and many investors considered the concept to be little more than a novelty.

While not as safe as investing in a treasury instrument, these bonds are as close to ironclad as a corporate bond can get. “These are the same companies that often make up the core of someone's equity portfolio,” says Patrick Kelly, managing director at LaSalle Broker Dealers, whose firm wholesales retail notes under the brand name DANs (Direct Access Notes). “It's a lot easier to convince a client to buy a corporate bond of a company whose stock is already in the portfolio.”

Another feature that makes retail notes more amenable to the individual investor is their simplified pricing scheme and liquidity. Once an issuer decides to come out with a retail note, a prospectus is posted. For instance, in December 2001, United Parcel Service came out with a retail note issuance of $600 million. If it had been a traditional corporate bond offering, a syndicate of investment banks and brokerage houses would have purchased the entire offering at once, divided it into smaller portions and then sold the pieces to clients.

Retail notes work differently. Each Monday, UPS sets the terms of its offering. For instance, during the week of January 6, the company offered a 14-year retail note that was callable in one year with an interest rate of 5 percent. A buyer is guaranteed that rate for the entire week. It can then be reset the next Monday for another week. “It makes it so much simpler for the buyer,” says Tom Ricketts, CEO of Incapital. “The price remains the same for an entire week, so you don't have to worry about a sudden change in pricing between your buy order and completion of the transaction.” The company will continue to issue bonds until the limit set in the prospectus is reached.

Probably the most unique feature of retail notes is the “death call.” Every note is callable at par by the issuer on the event of the owner's death. No other bond in the world has a similar feature. “I've gained clients because of the estate planning benefits of retail notes,” says George Gorian, who oversees the independent Gorian Investment Group in San Bernardino, Calif. “What happens to inheritors is one of the key concerns of elderly clients, and this is one of the few products that addresses that.”

While competitive rates are what sell these products to a client, it's the ease of use that sells it to the broker. “All you need to do to buy them is call your firm's trading desk and order them just like a stock. And they're excellent selling tools — you can use them to prospect for new clients,” says Kelly, who points out that you earn the same commission on them as you would with any bond transaction. “In a sense, these things were made to make the life of a registered representative easier.” Now that's some financial engineering we'd all like to see more of.