A Chart You Probably Don't Understand (Yet)

Note the period between September 2008 and the end of 2010. That was the heart of the crisis. It was the best time to buy bonds.

If you have to read that once or twice to really understand it, please do. It's critical that you understand what this chart means. Don't even think about buying corporate bonds unless you understand this chart.

Here's the easy way to understand it...

If I were going to sell you either a five-year U.S. Treasury bond or a five-year Stansberry Research bond, how much more interest would you expect from my company? You're either going to lend the U.S. government $1,000 or you're going to lend my company $1,000.

If we were offering you the same interest rate – the U.S. five-year rate is around 1.5% today – which bond would you choose? Most investors (all of them, actually) would pick the U.S. Treasury bond. While my company has been around for 15 years and has always been profitable (thanks to you, dear paid-up subscribers), nobody in his right mind would assume my company is as reliable as the U.S. Treasury.

Instead, I would have to offer considerably better terms to interest the average investor. Would you buy my bond instead of the U.S. Treasury bond if I offered to pay 5% a year? What about 10%? What about 20%? At some point, the average investor would decide that the higher yield offered by noninvestment-grade corporate debt is worth the risk.

This chart shows exactly how much more interest was required to make the average investor choose junk bonds. As you can see, the "premium" changes a lot based on the current default rate. As default rates for corporate bonds increase, investors become more leery of corporate bonds and demand higher interest rates to buy them.

At the peak of the last corporate-default cycle (during the spring of 2009), investors were demanding 22 percentage points more on each year's interest payments than they expected from U.S. Treasury bonds of similar duration. That's a huge premium. Those incredibly high interest rates make it difficult to lose money buying corporate bonds.

Keep this in mind: That interest-rate spread was created by the falling prices of corporate bonds. Imagine a corporate bond that was issued with an 8% coupon in 2006, maturing seven years later in 2013. During the last crisis, a bond like this would have had to offer investors something around 25% a year in yield in order to be sold.

If you read my earlier Digests about bonds, you already know that the coupon is fixed. It never changes. Thus, the only way someone could have sold the bond at that time was by discounting it heavily... by lowering its price more than 70%.

That's the corporate-default cycle in action. It can cause huge losses for investors, even if their bonds don't actually default. Think about an institution that isn't allowed to hold junk bonds. It might own several hundred million dollars' worth of bonds that get downgraded from investment-grade to noninvestment-grade. It then has to sell those bonds. But who is going to buy them?

It's this kind of forced, panicked selling – into a market that has generally poor liquidity – that causes bonds to be discounted so heavily. The best part is, since corporate bonds have average durations of around seven years, if you buy a corporate bond during one of these panics, you can earn high yields for years.

That's why the only time you should invest in junk bonds is during a crisis. That's the only time it's really worth it. This also explains why we recently launched our first bond letter (True Income) in 2008 and why we relaunched it as Stansberry's Credit Opportunities.

So, you might be wondering how True Income analyst Mike Williams fared during the last crisis.

Was he willing to buy deeply discounted bonds during the heart of the crisis? Did those bonds perform well? Did they provide investors with high total returns to compensate them for the risks of the corporate-bond market?

I went back and looked at every deeply distressed bond that Mike recommended following the Lehman Brothers bankruptcy from September 2008 to 2010.

I used the Lehman bankruptcy because it was the "bell" that announced a genuine crisis. I picked the end of 2010 to close on a year end and because by that time, the panic was clearly over in the bond market. I decided to consider a bond "deeply distressed" if Mike recommended buying it at less than $0.70 on the dollar.

I decided on these criteria before I reviewed the track record. But in fairness, I knew that Mike's recommendations averaged 16% annual returns from 2008 through the end of 2010. I knew Mike had done well... but I didn't know how he had done on his truly distressed recommendations.

The first deeply distressed deal he got into following the Lehman crisis was an International Lease Finance bond with a 5% coupon that matured in 2010. ILFC was a subsidiary of AIG. It owned airplanes and leased them to major airlines. This was a secure bond. The collateral was high-quality planes.

Mike recommended this bond in October 2008 when it was trading at a deep discount to par, only $0.69 on the dollar. It was sold at par in 2010, producing capital gains of just more than 50%. Investors would have also collected $50 in interest in 2009 and around another $25 in interest for the partial years' ownership in 2008 and 2009. That's $75 in interest, or a total yield of almost 11%. The total return, therefore, would have been around 60%.

Next, in February 2009, right near the peak of the crisis, Mike recommended what would go on to be one of our research company's best recommendations of all time – a Rite Aid 8.5% convertible bond due in 2015. Mike was able to get these bonds for only $0.32 on the dollar. They would go on to convert into stock and make total returns of more than 700%.

Mike would recommend four more deeply distressed bonds to his True Income subscribers. In September 2009, he found a Sears bond trading at $0.61 on the dollar. The bond matured at par a year later, producing a capital gain of 72%.

In March 2010, he recommended buying another convertible bond – this time, a Global Industries bond at $0.63 on the dollar. He sold it a little more than a year later for $0.98 on the dollar, producing capital gains of 56%.

Next, in September 2010, Mike recommended buying a Brunswick Corporation 7.125% bond due in 2027 for only $0.66 on the dollar. As you can see, to find distressed opportunities at this stage, he had to buy convertible bonds or be willing to go out a long time on his maturities. The crisis was passing and with it, so were the best opportunities. He recommended selling that bond after it reached par in June 2012, producing total returns of 55%.

Finally, the last truly distressed bond he recommended during the heart of the last crisis was a Liberty Media 4% bond maturing in 2029. Our buy price was $0.58 on the dollar. Today, this bond is still trading at precisely $575 – the same price at which he recommended it. But it has paid its coupon, earning investors almost 9% a year.

The average return of these six recommendations would be an absurdly high number because of the home run Mike hit with the Rite Aid bonds. That's why I didn't tell you the average. It isn't really representative because the sample size is so small.

What's far more important is that during this crisis, when most people were afraid to buy any stocks or bonds, all of Mike's recommendations performed well. Every single one. It's this irony – that the best and safest opportunities came during the crisis – that I hoped to show you with this analysis.

As bonds get cheaper and their yields go higher, they become safer.

The same isn't true in the stock market, as I'm sure you know if you've ever seen a high-dividend-paying stock decline in price and then cut its dividend. Remember, bonds are essentially binary: They either pay or they default. They cannot cut the coupon. That's why our analysis focuses so strongly on finding the bonds that will pay.

Since our experience with Mike and our first distressed-corporate-bond letter, we've had a lot of time to think about how to get even better results. Because of their binary nature and because the factors that lead to a default are almost all strictly quantitative (there's either enough cash or there isn't), there are plenty of ways to use computers (instead of a single analyst) to find opportunities in bonds. Using computers would allow us to screen every single bond and not just rely on the kind of stock-by-stock sleuthing that leads us to make equity investments.

To do this successfully, I've built a team of analysts and I've spent a fortune on computers and data. There are two accountants (Bryan Beach and Mike DiBiase), who have a combined 30 years of experience with public companies.

We have an experienced lawyer (Bill McGilton) who has read thousands of contracts and bond debentures. That's critical, because you have to know how each bond differs in the collateral structure that underlies it. And of course, we have two market analysts – Brett Aitken and me. We have experience with many of these issuers from the equity side. We know the relative quality of these businesses.

We start our research process with the entire U.S. universe of corporate-bond issues: 40,000 in all. We screen for maturity of less than five years, which greatly reduces the risk of default. And we screen for an original issue amount of more than $500 million, which gives us the best chance at enough liquidity to get into these investments.

That gets us down to a more reasonable universe of around 5,000 different bonds from around 1,000 issuers. All of these issuers are given a score with our proprietary ratings system.

Our rating process is similar to the major agencies' – Moody's, Standard & Poor's, and Fitch. We know that because we compare our ratings against theirs. The biggest difference is that our ratings are purely quantitative. The ratings agencies talk to companies' management. We won't let their rosy presentations influence our ratings.

Lastly, we only rate issuers, not individual bonds. You could argue this is a shortfall of our approach, but if the goal is only to pick bonds that aren't going to default, then the subordination of individual bonds is irrelevant.

Our system reduces a huge population of potential investments down to a couple dozen companies to look at. Then the manual part of our process begins. We scan the list and throw out any companies you wouldn't want to loan money to because they have a high probability of defaulting. We consider the debt of these companies to be toxic.

This makes it easy to identify a handful of bonds to really dig into. Important: Our system finds bargains at all different levels of risk. Sometimes there are completely safe bonds that are trading at a discount. For example, on one of our first total-market screens, we found a great little insurance company with more cash than debt. Why in the world are its bonds trading at $0.95 on the dollar?

During this "manual" stage, having a lawyer on staff is critical. In this case, Bill rolled up his sleeves and found some fine print that shows if there's an all-cash takeover for this company, the bonds could convert to around 20 shares of stock. There's no guarantee these shares would fully cover the face value of the bonds. There is no way a 100% automated system would catch stuff like this, which is why we study everything fully before we recommend it.

In the end, we're left with a small group of bonds that offer us compelling yields in return for the actual risk we face. We will publish a sample of these names in every issue, showing you more than just the bond we recommend you buy. This will allow you to diversify your investments across the bonds that show up on our screens.

It will also give you a wide range of bonds to consider at various risk levels. For example, here's our best selection of "distressed" bonds at the moment. Keep in mind, these aren't recommendations. The prices of many of these bonds have been driven up in recent months by investors chasing yield as interest rates are now negative in many places around the world.