How to Find the 'Needle in the Haystack' in the Market
Editor's note: The best time to invest in junk bonds is during a crisis.
And as longtime Digest readers know, Porter believes a crisis unlike anything we've ever seen before is simply a matter of when, not if.
Unfortunately, for the majority of investors, simply reading the word "bond" makes their eyes glaze over and lose interest.
They're making an enormous mistake...
Just take a look at our performance in Stansberry's Credit Opportunities. Of the 11 positions we've closed since launching our bond newsletter, 82% have turned a profit, with average annualized gains of 36%.
It's no wonder Porter gave Stansberry's Credit Opportunities an "A++" in the 2016 Report Card. But less than 10% of Stansberry Research readers are taking advantage of this exclusive research.
Today's Masters Series features the conclusion of an essay Porter wrote in a November 2015 Digest series. In it, he'll show you how he built a massive analytical engine to find the best opportunities in the market... and how you'll know when the inevitable crisis has arrived...
How to Find the 'Needle in the Haystack' in the Market
During the last crisis, when most people were afraid to buy any stocks or bonds, almost all of our bond recommendations performed well. 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 as 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 the company cuts 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 first distressed-corporate-bond letter (True Income), 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), both of whom 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 normally screen for maturities of less than five years, which greatly reduces the risk of default. And we screen for an original issue amount of more than $150 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 those of the major ratings 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 are in a long-term decline – like newspapers, for example.
This makes it easy to identify a handful of bonds to really dig into. It's important to note that 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 were 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.
It gives you a view of the wide range of bonds we are considering at various risk levels. For example, here's our best selection of "distressed" bonds at the moment. Keep in mind, these aren't recommendations – at least, not yet. These are the bonds that our system indicates are trading at lower prices and offering higher yields than we think their rating warrants...
As you can also see from our pie chart, nearly 98% of the bonds that have received a "distressed" rating from us are not yet trading at a significant discount to par. Some of them are still trading at a substantial premium to par. This indicates that we are still a long way from our best buying opportunities. Until this market falls a lot more in price, we probably won't be recommending many distressed bonds. Instead, we'll focus on the opportunities in our "moderate" risk category.
Even so, remember... no matter how well we do our jobs... sooner or later we will recommend a bond that defaults. And that's bad. It's impossible to know with any precision what the outcome of a default will be. In some cases, like the General Motors bankruptcy, the bondholders are simply ripped off in clear violation of the U.S. bankruptcy code.
In other cases, investors who are able to provide "debtor in possession" financing end up siphoning away all of the remaining assets. That's why you want to avoid buying a bond that defaults. Having said that, it's important to know that bonds offer far less downside, on average, than stocks.
Here are the facts, as compiled by Moody's, the world's largest bond-ratings agency...
Moody's has kept default statistics on bonds since 1920. While these statistics don't include every bond ever issued, they do cover the majority of the U.S. corporate-bond market. Thus, from a statistical perspective, these records are many times larger than required to constitute a reliable sample.
From 1920 to 2008, the 10-year default rate on the lowest-rated, investment-grade corporate bonds ("Baa") is only 7%. The recovery rate on senior unsecured bonds from 1987 through 2008 was 46.2%. Investors who buy even the lowest-quality investment-grade corporate bonds rarely experience a default (7%), and even in these tough cases, investors recovered almost half of their principal (46.2%).
Another way of reducing risk is to only buy bonds with shorter durations. The default rate plummets as you move the duration of your portfolio into shorter time frames. From 1920 through 2008, the default rate on investment-grade corporate bonds in their first five years of trading was only 3.1% – less than half of the 10-year default rate.
These low default rates and high recovery rates are why I say it's virtually impossible to lose money by investing in investment-grade corporate bonds as long as you diversify.
And here's the ironic thing... According to various studies of actual investor behavior and returns, even if you only earn 5%-7% annually on these safe corporate bonds, that would be more than most stock investors made, on average, during the roaring bull markets of the 1990s and the 2000s. Studies show that individual investors typically earn around 3% a year in stocks, on average, because they tend to always buy at market tops and then sell at market bottoms. If you're honest, you might discover that you would have been far better off only buying bonds than stocks.
Ah... but greed exists. Thankfully for newsletter publishers, everyone thinks he can beat the odds and build his own George Soros-like investment account. Who knows, maybe you can. The best stock investor over the longest period of time is Warren Buffett. His long-term compound return in stocks is almost 20% annually.
I believe Buffett is likely to be at least twice the investor as anyone reading this essay (and also the guy writing it). So anyone who can earn 10% a year or more on their entire portfolio is doing a great job. Expecting to earn more will almost surely lead to disappointment. No, it's not impossible. Long-term studies of Steve Sjuggerud's investment recommendations in True Wealth reveal average annual returns in excess of 15%, which is extraordinary. But it's unlikely that most stock investors will do that well.
What might help you bridge the gap? You're probably far more likely to make 10% average annual returns – or a little more – by investing in noninvestment-grade corporate debt than you are investing in stocks. As you've seen, it's possible to get double-digit yields when you buy these kinds of corporate bonds at a discount. And if you're earning more than 10% a year on coupons alone, it would be nearly impossible not to make substantially more than that on average, as long as you have a fairly diversified portfolio.
Of course, there are risks. According to Moody's data, the five-year cumulative default rate for B-rated bonds ("junk bonds") is a little more than 21%. So you have to be careful. Default is a real possibility on any of these bonds that have more than a five-year duration (and even on some that don't).
Keep in mind, the junk-bond market didn't develop until the 1980s. So when studying recovery rates, it's important to remember that the sample size isn't as large as the investment-grade corporate market. Moody's only has data on junk bonds from 1982 through today. During that period, the recovery rate for unsecured A-rated corporate bonds was 41.3%. The recovery rate on unsecured B-rated junk bonds was 37.3%. The recovery rate on noninvestment-grade bonds is very close to the recovery rate on investment-grade bonds.
Considering how much more interest you can earn in junk bonds, it's fair to say that you're far better off owning a junk bond that defaults than you are owning an investment-grade corporate bond that defaults. That's surprising, isn't it? Well, just remember... junk bonds default about three times more often, so it's a misleading stat... but it's still true.
In short, when you're buying junk bonds, you should wait until they are trading at a big discount to par ($100). This allows you to reduce your risk tremendously, as yields on these bonds will normally be in excess of 15% annually. If you know the average recovery on these bonds will be around $40 and you can get two years' worth of interest payments (say, $30 in total), you really aren't risking much capital.
Even so, you want to avoid default, because the big gains are earned when you cash out at par ($100). And the way to avoid default is to make sure that the company in question has the cash to pay you. As bonds are binary, that's all that matters. The business doesn't have to do well... it just has to have enough cash to pay you.
Regards,
Porter Stansberry
Editor's note: This Wednesday, December 6 at 8 p.m. Eastern time, Porter is hosting a free live event where he'll share what he's calling "our most lucrative discovery ever." It's a unique strategy that can potentially double your money in the next 12 to 24 months. Reserve your seat for this free event right here.