Editor's note: Are you prepared for one of the best investment opportunities of the past 50 years?
In yesterday's edition of our weekend Masters Series, we shared the first part of Stansberry Research founder Porter Stansberry's classic interview on buying discounted – or "distressed" – bonds.
Today, Porter explains the real secret to making a fortune in the bond market, while taking virtually no risk at all...
Lower Your Risk and Still Beat the Market
An interview with Porter Stansberry, founder, Stansberry Research
Stansberry Research: Are there any important strategies for buying these bonds that we need to know about?
Porter: Well, there's a wrinkle in 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 $100 bond for $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 $100 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?
Porter: One of the big reasons corporate bonds trade at such big discounts 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 of 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 smart investors – the so-called "vulture investors" – can find fantastic opportunities. That's why we're relaunching our distressed-debt newsletter soon. I believe that there will be incredible opportunities to make huge returns buying discounted corporate bonds.
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?
Porter: 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 less than $5 rarely get back to more than $5. Those kinds of losses usually only happen 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.
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 been worth. 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.