Buying Discounted Corporate Bonds
This interview is with Porter Stansberry, founder of Stansberry Research.
We sat down with Porter to discuss one of his favorite investment strategies. It's an idea he says literally changed his investing life, and one he thinks all investors should become familiar with – buying discounted corporate bonds.
We know most investors think buying bonds is about as exciting as watching paint dry, but this idea may surprise you. Porter says when the conditions are right, you can double your money while taking on zero risk.
To learn how, read on...
Stansberry Research: Porter, you've written a great deal about corporate bonds. In fact, you've gone so far as to say that learning the correct way to buy them will literally change an investor's life. What's so great about buying discounted corporate bonds?
Porter Stansberry: Well, it's probably better to begin by describing what's not so great about buying stocks.
Stocks are really only worth what you can sell them for in the market, or what they'll pay you in dividends over time. But there are two problems with this... Neither of those values is guaranteed.
First, there is no guarantee that when you go to the market other people will pay what you expect for your stock. In fact, there's no guarantee they'll pay anything for your stock.
Secondly, there is no guarantee that you're going to receive the dividends you expect. Dividend policy is totally the domain of the board of directors. Unfortunately, in public companies, most boards are terrible... Most simply don't care about shareholders. So, you're truly at the mercy of the board... or at the mercy of the marketplace.
Frankly, that doesn't sit well with me... which is why I only buy stocks when they're extremely cheap or have proven track records of paying dividends. Unfortunately, that means many times there's just nothing for me to buy.
Stansberry Research: So what are the advantages of buying bonds?
Stansberry: The advantages of buying bonds are precisely that you do get those guarantees... You're guaranteed to get some percentage of your invested capital back. You're guaranteed to receive a dividend.
In simple terms, a bond is nothing more than a loan... It's a loan that you make to a corporation in the form of a security. Say you buy a typical $1,000 bond. That means the company agrees to pay you back your $1,000 in full at a certain point in the future. It can be a short-term loan or a longer-term loan... It could be 30 days or seven years. There are all kinds of different terms and periods. But the most important thing is that at the end of the term, the company – by law – is required to pay par, which means the full price of the bond as it was underwritten.
Believe it or not, sometimes you can go out in the marketplace and find bonds that by law are obligated to repay investors $1,000, but that are trading for $800, $700, sometimes even $500 or $400. These are referred to as discounted corporate bonds.
By the way, some new investors are confused by the lingo here. In the bond market, they don't say these bonds are trading at $800... They say they're trading at $80. They don't say they're trading at $500... They say they're trading at $50. A simple way to think about this is to multiply the terms by 10 to get the real dollar amount... For example, $80 multiplied by 10 is $800.
The amazing thing about these discounted bonds is you have a legal claim on that corporation to be repaid in full... a legal claim. It's not a matter of what the market will decide to pay you. The company has to pay you back in full, or else it goes bankrupt and all the assets the company has are sold off and the value of that sale is distributed to all the bondholders.
Now, I'm not suggesting you want to buy bonds that are going to go bankrupt. That usually ends up being a painfully long process, and it might take you years to get your money back. That's not the idea.
The idea is to find bonds where the assets can clearly cover the bondholders so that bankruptcy does not have to occur. Instead, asset sales will happen and the company will pay back the bondholders without going bankrupt. You see this happen all the time.
So when you choose the right bonds, you're basically guaranteed to get a good return on your investment.
Stansberry Research: And the second advantage?
Stansberry: The second advantage of bonds is they pay a fixed coupon. Remember, I said the other problem with stocks is their dividends are decided by the board of directors. The truth is that most stocks don't pay any dividends at all, and often times if they do, they're so small it's hardly worth it.
But you can know exactly what a bond will pay you because the interest payment – it's called a coupon for bonds, rather than a dividend as it is for stocks – is fixed. You know exactly when and exactly how much you're going to get paid... so you can know exactly what the yield will be from your investment.
Stansberry Research: Can you give us an example of how this works?
Stansberry: Sure... Let's say you buy a particular corporate bond at a discount. You pay $0.80 on the dollar, and the term of the bond is one year. You know that one year from now you're going to make a profit of $0.20 on the dollar, because you're buying it at $0.80, and you're going to get a full $1 when the company pays you, because the bond has to be paid back at par. If par is $1,000, then you're paying $800 for the bond.
So, right off the bat you know you're going to make $200, or 25% on your money that year. That's a pretty good return, and it's guaranteed by the company... it's a legal obligation. But it gets even better.
The second way you're going to get paid is over the course of the year you're going to get coupon payments. On a fully priced bond, a coupon might be 8%... so in this case you're going to get a total of $80 from the bond that year. That's another $80 on your original $800 investment, or an additional 10% return on your original capital invested. In total, on this one deal, you're going to make 35% on your money.
What is the risk that you took on this deal? The risk in this case was the company would go bankrupt and would have to repay you over time. Instead of getting your money back in a year, it might take two or three years. That's no good... We don't want that. But it's a heck of a lot better than if you buy a stock and it goes bankrupt and you get nothing back ever.
Again, the idea is not to buy bonds that will go bankrupt, but to buy bonds where the company has plenty of assets available to repay their bondholders without having to go bankrupt. That's the essence of buying corporate bonds at a discount.
Stansberry Research: Are there any important strategies for buying these bonds that we need to know about?
Stansberry: Well, there's a wrinkle to the process that I want to discuss, because it's the real secret behind the people who make a lot of money in bonds.
The average recovery rate for corporate bonds that have gone bankrupt over the last 50 years or so is about $0.45 on the dollar.
So, if your bond goes bankrupt, chances are you'll get about $0.45 on the dollar... Sometimes you might get less, sometimes you might get more.
This is where being an analyst becomes important. You have to know what the liquidation value of the corporation is. An analyst spends all his time figuring this out: What is this company worth if the worst happens and it goes bankrupt? Can we get our money back? That's the big consideration before you buy any discounted bond.
But forget all that for now... Let's assume you don't know any of those things. You decide you're going to buy a bond at $60. Since we know the average recovery rate is $0.45 on the dollar, if the bond does go bankrupt, your expected loss is about $15. So you are taking a 25% risk, but what are you getting in return?
In return you're getting the right to be paid the par for that bond if it doesn't go bankrupt... You'll make $40 on a $60 investment. Now, again, these are bond market terms... The reality is the bond costs $1,000, you're going to invest $600, and you're going to get a $400 profit for doing so. That's more than a 65% return... a huge gain.
You're risking $150 to get $400... That's a much better risk-to-return ratio than you'll find in the stock market. You're always risking less in bonds... and if you buy discounted bonds you can actually make profits that are larger than average in the stock market. This is why many of the richest people in the world spend more time and money on bonds than they do on stocks.
Stansberry Research: If the risks are so low with these bonds, why do they often trade at such big discounts?
Stansberry: One of the big reasons corporate bonds trade at such a big discount is because a lot of institutions that own bonds – like insurance companies, pension funds, and a lot of bond funds, banks, and brokers – are not allowed to own them if the bonds lose their investment-grade credit rating.
When a company stumbles or has a couple bad quarters, the bonds can get marked down by Moody's and Standard & Poor's. They can go from investment-grade rated to what's called junk-rated. But junk-rated doesn't mean what most people think. It doesn't mean that the company is "junk," it simply means that the company's cash earnings necessary to fully cover the bond's coupons are becoming jeopardized.
It doesn't mean that the coupons won't get paid. It doesn't mean that the company will go into bankruptcy. It means nothing at all about the future recovery value of those bonds. All it means is that this company has stumbled, its earnings are weaker, and there is a greater chance – far from guaranteed – that they'll miss a coupon payment.
So when that happens – when there's any chance of a missed payment at all – the company goes from investment-grade to non-investment grade, and all these institutions are forced to sell... There's an entire cohort of the largest money pools in the world that can no longer own them, and they tumble in price.
This is where people like myself and a lot of other smart investors – the so-called "vulture investors" – can pick up fantastic opportunities.
The professional investors who specialize in discounted corporate bonds tend to be the smartest people on Wall Street and tend to be the most rigorous about what they pay. Not coincidentally, they also tend to make the most money.
Stansberry Research: Is there anything else we should know about discounted corporate bonds?
Stansberry: There is one last thing that I want readers to understand.
If you're buying a stock that was trading at $100 six months ago and now it's trading at $5, the odds are that stock is going to zero.
Stocks that go from $100 to below $5 rarely get back above $5. Those kinds of losses usually only happens if there's a serious problem in that company. Serious problems are bad news for stockholders, because they have no real claims in bankruptcy. So sometimes when you think you're buying a super-cheap stock, you're actually taking a huge risk... where there's an excellent chance that you'll end up with nothing.
This is the fun part about bonds... The lower the price of a bond, the more likely you'll make money. It sounds unbelievable, but it's true. The lower the price of the bond, the lower the risk, because the closer it gets to the recovery price.
For example, I personally made a lot of money buying bonds in General Motors. This is somewhat ironic because I had been predicting for years that General Motors would go bankrupt... and of course it did.
But after it went bankrupt, I was able to buy its bonds for between $0.15 and $0.20 on the dollar. I had done my homework, and I knew the liquidation value of the bonds would be somewhere around $0.40 on the dollar.
Well, along came the Obama administration... They completely ignored all the bankruptcy laws, and they ended up giving 40% of the company to the unions, which was unbelievable and unheard of.
Because of that, the bonds only ended up being worth about $0.30 on the dollar at bankruptcy, rather than the $0.40 on the dollar they otherwise would have. I ended up making less than expected, but I still almost doubled my money in 18 months with no risk.
Now, I'm sure some people will think, "What do you mean you had no risk? You're buying bonds in bankruptcy, of course you had risk." But the fact is I didn't.
I knew what the bonds would be worth in bankruptcy, and I knew the bankruptcy process would not last a decade. So, I had no real risk. If more people understood this, it would completely change their financial futures.
Stansberry Research: Thanks for talking with us.
Stansberry: My pleasure.
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