What are baby bonds, and how do they work?

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• A "baby bond" is a bond with a face value that falls below $1,000 — typically $25 or $50.
• Anyone can invest in baby bonds as long as they meet the associated minimum requirement.
• Baby bonds are unsecured, meaning you aren't guaranteed payment in the event of a default.

Unlike stocks, ETFs, and mutual funds, bonds are debt securities that pay interest over certain terms. Some have fixed interest rates and others have variable rates, but there are many different types of bonds you can use to build wealth.

These include treasury bonds, high-yield bonds, municipal bonds, and corporate bonds. But there's also another type: "baby bonds." Below, we explore how baby bonds work, as well as the benefits and drawbacks of investing in them.

What are baby bonds?

Baby bonds generally refer to bond debt issued in denominations smaller than $1,000 par, according to Michael Ashley Schulman, CFA. Par value is the same as face value or principal, and it represents the original amount you pay for a bond.

"Corporate baby bonds often function much like regular bonds but trade on public stock exchanges in smaller increments than regular bonds, which normally trade over the counter or outside of an exchange," he explains. "They are designed to be easier for smaller investors to follow and trade—although that is not always the case."

Who is eligible to invest in baby bonds?

When it comes to the tradeable baby bonds, anyone is eligible to invest. But it's important to note that minimum requirements may vary depending on the company that issues the bond, says Dennis Shirshikov, Strategist at Awning.com.

And as mentioned earlier, baby bonds usually have a minimum investment of $1,000 or less, though some can offer significantly lower par values. For instance, Aegon Funding Company LLC (AEFC) has a $25 par value and 30-year term.

How do baby bonds work?

Baby bonds resemble other types of bonds in that each type involves an issuer and an investor. The investor provides the funding and receives regular interest payments over the lifetime of the bond. But baby bonds come in smaller denominations (i.e., amounts of $25 or $50), hence the use of the word "baby."

They are typically issued through an underwriting process, similar to other types of securities, and the issuing company or municipality hires an investment bank to handle the sale of the bonds to investors, according to Mina Tadrus, CEO of Tadrus Capital. The bonds, he adds, can be purchased through brokerage firms or directly from the issuer.

Another thing to note about baby bonds is that they're usually callable, meaning that the issuer doesn't have to pay you interest until the bond matures. If they decide to redeem the bond before it matures, they'll pay you both the original par value (principal) and any interest the bond has earned. This is an important thing to keep in mind, especially if you're setting on earning the full interest amount for the lifetime of the bond.

What are the pros and cons of baby bonds?

As debt instruments, bonds can offer unique advantages. This includes guaranteed interest payments. Plus, interest earned from municipal bonds generally qualifies for a federal income tax exemption (and sometimes a state and local tax exemption), according to investor.gov.

And as mentioned earlier, one huge quality that separates baby bonds is that they generally cost less than regular bonds. Bonds typically cost at least $1,000, so baby bonds could be a great option for investors who want to save money.

"Baby bonds may offer higher yields compared to other fixed-income investments, making them a potentially attractive option for those looking to maximize their returns," says Tadrus. "Another advantage is the opportunity to invest in specific companies or municipalities, allowing investors to align their investments with their values or goals."

However, problems can arise for those who don't want to wait it out until the bond matures. You'll receive both the original face value and accumulated interest the bond has generated if you hold until its term ends (or if the issuer recalls it), but you could jeopardize returns if you sell early.

"Lack of liquidity is also frequently an issue when trading, as bid/ask price ranges can be quite wide," explains Schulman. If one had to get out of a large quantity of baby bonds quickly, he adds, the price could be driven down in the short-term just on a single person's selling pressure.

And since baby bonds usually classify as unsecured debt, you aren't guaranteed interest payments if the issuer needs to default or recall the bond.

Should you invest in baby bonds?

Due to their lower face values, baby bonds can offer a less expensive entrance into bond investing. Plus, they can be useful for portfolio diversification and higher yields. However, liquidity could be a concern, and their unsecured nature puts investors at risk in the event of issuer defaults. 

"It's important to carefully review the terms and conditions of a baby bond before investing, including the creditworthiness of the issuing company and the terms of the bond, such as the interest rate and maturity date," says Shirshikov.