From Brad Hoppmann: Corporate debt is drawing considerable interest from investors these days, and for good reason — its combination of high yield and low risk is a rare find.
Good friends are hard to come by.
In fact, I’ve heard it said that if you have more than a handful of people you consider really good friends, then you probably don’t have any actual really good friends.
I consider myself fortunate to have one really good friend in my life who also has been a mentor of mine professionally. His name is Porter Stansberry, and he is the Founder and CEO of Stansberry Research.
Recently, Porter told me about a new strategy he’s been researching that shows investors how to make money in distressed corporate bonds.
It’s interesting — he’s been toying with this idea for a couple years and just in the last few weeks he and his team have made a massive breakthrough. And after he explained to me how it worked, I asked him if I could share some of the highlights with my Uncommon Wisdom Dailyreaders.
The always-generous Porter agreed to do just that. So today I am going to give you a few broad strokes on his new “Transfer of Wealth” thesis, so that you can see what I’m so excited about.
Although the stock market is a fantastic wealth-building vehicle, in many ways it’s easier to investsuccessfully in bonds.
First, bonds are much safer and easier to value than stocks …
When companies (or governments) sell bonds, they make a promise to pay interest and to repay 100% of the principal. The same legal structure that makes bonds safe also makes them easy to understand and easy to value.
The “ease of use” here comes from the fact that a bond has only two primary components, the first being price and the second being its coupon.
The key to understanding bond prices and how they might change is to always remember that the coupon is fixed. As interest rates change, the prices of bonds will fluctuate. If interest rates go down, everything else being equal, the price of your bond will go up. That’s because the coupon is fixed.
Now, during periods of tightening credit conditions and increasing credit-rating downgrades, there will be huge pools of fairly safe bonds (not completely safe, but fairly safe) that must be sold, and only a few institutions that are allowed to buy them. This forced selling creates huge market inefficiencies.
It is these market inefficiencies that Porter has found a way of identifying and exploiting to help investors go for massive gains.
The Binary Advantage
One of the biggest reasons bonds can be so powerful as investment tools is because of their “binary” nature. This means that there are only two outcomes with bonds — they are either paid, or they aren’t paid. The issuer either services the debt payment, or they default.
This binary nature is very different than stocks. It is this salient feature that Porter told me is the main reason why he thinks most investors are far better off in bonds than in stocks.
That’s because owning bonds allows you to make sure that you get paid no matter what. And even if the company defaults on its bond obligations, a committee of bondholders will foreclose and take all of the company’s remaining assets. This can greatly reduce your risk of capital loss — even when you buy the riskiest bonds.
Another way to greatly reduce your risk is to own a diversified group of distressed corporate bonds.
What this means is that if you’re going to invest in corporate bonds, you have to diversify your holdings. Porter recommends investors own at least 10 corporate bonds at all times.
The reason why is again due to the binary nature of these debt instruments. Either the company pays, or it defaults. So, if you only have a few holdings and they all default, you are in trouble. But if you have 10 holdings and only three default, then you still have some 70% of your holdings that are winners.
Over the next three or four years, Porter anticipates that there will be a tremendous amount of distress in the corporate credit markets. That’s because the credit cycle has turned, and credit is tightening.
This means that the default rate for bonds is going to go higher and higher until it reaches a new zenith. During the cycle, Porter expects that 30%-40% of all non-investment-grade bonds will default. That means neither Porter, nor I, nor anyone else will be able to avoid owning some bonds that will default.
Because you most likely won’t be able to sell bonds that go bad, as no one will buy the bonds you hold, the only way to limit risk is to limit your position size. That’s why Porter’s diversified buying strategy is so important to remember. The only safe way to succeed is to buy a portfolio of bonds in a diversified manner that includes bonds from a variety of industries, and a variety of risk profiles.
Perhaps the most important element of this strategy, and the one that makes it so compelling from my viewpoint …
Is that the greatest corporate bond investing opportunities really only emerge during periods of financial stress.
The Expert Vetting Process
Like he has his entire career, Porter has assembled a team of experts … this time in the distressed corporate debt universe. These experts know how to discover and analyze the best opportunities out there for individual investors.
That team starts its research process with the entire U.S. universe of corporate-bond issues, some 40,000 in all. Then they screen for maturity of less than five years, which greatly reduces the risk of default. They also screen for an original issue amount of more than $500 million. This provides the best chance at enough liquidity to get into these investments.
That narrows the field down to a universe of around 5,000 different bonds from around 1,000 issuers. All of these issuers are given a score within Porter’s proprietary ratings system.
What I like about these ratings is that they are purely quantitative, and don’t rely on qualitative assessments of the companies the way Moody’s and Standard & Poor’s do. Those ratings agencies talk to companies’ management, but fortunately for us, Porter doesn’t allow their rosy presentations to influence his ratings.
Once the vetting process is complete, the Stansberry team has whittled its selections down to just a couple of dozen companies. Then the experts in Porter’s group scan the list and throw out any companies you wouldn’t want to loan money to because they are in a long-term decline. This makes it even easier for his team to identify a handful of bonds to really dig into.
In essence, Porter and his team of experts are doing a lot of the heavy research lifting to identify these most-intriguing distressed corporate bond opportunities.
Then they go several steps further by identifying precisely which group of bonds to buy so you can diversify your holdings in terms of both industry and risk profile.
Like Porter, I am convinced that discounted corporate bonds offer investors an outstanding combination of high returns and safety. That’s because, with these bonds, you have the opportunity to make capital gains that are better than the average returns in stocks … while also earning high rates of current yield. Plus, investors can make these returns with securities that are far safer than stocks.
It is this unbeatable combination of returns and safety that has so intrigued me. But I want you to take a look at Porter’s research for yourself. Dig in. See what you think.
Click here for all the details on the opportunities Porter and his team of experts are finding in distressed corporate debt.
The iShares IBoxx $ Investment Grade Corporate Bond Fund (NYSE:LQD) closed at $123.79 per share on Thursday, down $0.12 (-0.10%). The largest ETF tied to investment grade corporate debt currently yields about 3.2%, and its price has risen 8.6% year-to-date. LQD also offers a low expense ratio of 0.15%, making it particularly attractive for long-term investors.
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