Baby Bonds

Baby bonds refer to debt instruments issued in smaller denominations. The par value of these fixed-income securities is lower than $1000. These fixed-income securities attract retail Investors who cannot invest in larger denominations.

They are issued by an array of issuers—small companies, state governments, municipalities, etc. These are tradable yet unsecured bonds. They are issued at a discount and recognized as zero-coupon bonds. Most such bonds are exempt from taxation.

• Baby bonds refer to the unsecured fixed-income securities—face value ranging from $25 to $500. It is issued by the municipalities, state government, central government, or small corporations.
• The bonds mature within 8 to 15 years and are issued with a callable option (which can only be exercised after five years).
• Governments issue such bonds to fund projects with long gestation periods and heavy capital expenditure.

Baby bonds are exchange-traded debts that enable small investors. Small investors can avail of bond instrument benefits with low face values—as low as $25, ranging upto a maximum of $500.

Small companies cannot issue large bonds. But, they can issue baby bonds without compromising on liquidity. In the UK, some parents save every month for ten years; in return, their children are issued tax-free baby bonds.

These bonds are not secured with any collateral. The maturity period varies between a minimum of 5 years and a maximum of 50 years (usually between 8 to 15 years).

These bonds are mostly callable, which in any case is not less than five years from the date of issue. Moreover, these securities offer higher yields than normal bonds—due to added risks and the call feature.

The first baby bond was issued by the US government in 1935. President Franklin D. Roosevelt created the Baby Bond Program to encourage the habit of saving. The government needed to fund hefty expenditures on the civil war—issued bonds.

In 1935, the US government also came up with lower denomination bonds called A- bonds; it was a kind of baby bond. Later, B-bonds, C-bonds, and D-bonds were issued in 1936, 1937, and 1938 respectively. The bonds traded at 75% of face value, and the maturity period was ten years.

Contemporarily baby bonds are released by municipal corporations, cities, and states. They are zero-coupon bonds that mature between 8 and 15 years. In the 1990s, the UK saw the emergence of savings for children. Parents contributed a certain amount every month for ten years. In return, their children received a tax-free bond fund as a lump sum of money—as soon as they turned 18.

In 2005, the UK launched a Child Trust Fund for the children—who took birth after September 1, 2002. Every child received a €250 voucher for opening an account. 

Jason is interested in diversifying his portfolio. He spends a portion of his investment on bonds; however, he wants to keep his investment limited to $1000.

He has two options:

1. Option 1: Invest in a single bond with a face value of $1000.
2. Option 2: Invest in baby bonds issued by a utility company that offers small-denomination bonds of $50. These bonds offer a high yield. In addition, Jason can invest in $500 municipal bonds for portfolio diversification.

Thus, Baby Bonds offer diversification and high yield despite investing less. However, it is pertinent to note that these benefits come with additional risks. These bonds are unsecured in nature and offer less liquidity (compared to traditional bonds).

In 2021, these bonds got a lot of attention. Presidential candidate Cory Booker proposed a $1000 initial contribution for every child born in the US. He also promised an additional contribution of $2000 year on year till the child attains adulthood—subject to family income estimates.

According to the proposal, a child belonging to an affluent family will get around $1700, whereas economically challenged children could benefit as much as $46000. The fund was meant for higher education and retirement needs.

The financial instrument has the following advantages:

• Affordable: Even average retail investors can purchase baby bonds—available in small denominations—starting at $25.
• Tax Efficient: Fixed income securities issued by the municipalities are usually free from taxes. 
• Callable: After five years, the issuing company can call these bonds back (beneficial to the issuers).
• Better Returns: They offer a higher yield (compared to traditional bonds) due to the callable feature.

The bond suffers from the following disadvantages:

• Unsecured Debt Instrument: These bonds are largely unsecured, with limited or no collateral—increased credit risk. In contrast, secured creditors have the first right over assets when a borrower defaults.
• Lower Returns: The issuing companies can call the bonds after a particular period—loss of interest income. They are susceptible to reinvestment risk (investing in lower-yielding bonds).
• Default Risk: These bonds are usually issued by small companies that cannot attract large institutional investors—and come with higher default risk.
• Lower Returns in Market Downfall: Due to the small issue size, it is difficult to sell these bonds in a failing market. The Bid-Ask spread can be high while the yield is low. During economic slumps, it aggravates further—these bonds are not very liquid.

This article has been a guide to Baby bonds & definition. We explain baby bonds, how they work, "save for college" funds, pros, cons & examples from the US & UK. You can learn more about financing from the following articles -

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