Why Bond Investors Should Be Hoping for a Financial Crisis
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Have you ever made that kind of return in a little more than a year? Most people haven't... and never will.
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In today's Masters Series – adapted and updated from a November 2015 Digest series – Porter shares an important chart... and explains why times of crisis are great for a certain group of investors...
Why Bond Investors Should Be Hoping for a Financial Crisis
Let's begin with a thought experiment. Let's test the hypothesis...
My interest in buying distressed corporate debt lies in a belief that the market for lower-quality corporate bonds is extremely inefficient. That's because major institutional investors won't buy (and often are not allowed to own) distressed corporate bonds and because most individual investors know nothing about these securities.
Likewise, the market is inefficient because there is limited access to information about these securities. Their filings to the U.S. Securities and Exchange Commission (SEC) are hundreds of pages long (which intimidates most investors, even professionals) and just getting a price quote can require making a phone call and waiting five or 10 minutes for a broker to call around. All of these factors contribute to an illiquid market. The upside of these inconveniences is that securities regularly become totally mispriced relative to their underlying value and security.
That's a big part of the reason I want to pull my hair out when subscribers complain about having to use a nine-digit CUSIP number... or about having to use the phone to buy a bond... or about having to wait a week – a whole week! – to close the purchase of 100 bonds.
Yes, dear friends... buying distressed corporate bonds can be a pain in the neck. But it is this friction that creates the opportunity we have today. If buying bonds were as easy as buying stocks... if the information on bonds were as widely available... if investors were tremendously interested in these securities, with hundreds of institutions set up to research them and to make markets in them... then all of these inefficiencies in pricing would disappear. They would be easy to buy. But they wouldn't be worth buying.
Just think about that for a minute. The same factors are in play across every market, for any kind of product or service. For example, I enjoy a good cigar every now and then. You can buy cheap cigars at just about every gas station in America. But try finding a genuine Cuban-made Cohiba Behike.
Likewise, you can buy a cheap hamburger at any one of McDonald's 14,000-plus U.S. locations for around $1. But try finding a genuine, ground ribeye burger at any fast-food joint. You won't be able to. If you're looking for the highest quality, or even the most value (which is not found at the lowest price), you have to shop around.
The same thing is true about investments. The best investments you will make in your life will almost always be harder to find and less liquid than simply buying common stocks. Complaining about the inconveniences of trading corporate bonds is tantamount to complaining about the opportunity in corporate bonds. You can't have one without the other.
The best time to buy corporate bonds is during a crisis. That's when other investors are trying to (or are forced to) sell them. That's when the yields on these securities can reach absurd levels, offering you more protection from default. That's when the prices of these securities often fall to absurdly low levels, which offers you even more protection from default.
If I'm right about these ideas, then an average analyst should have been able to find incredible investments during the last big credit cycle.
I've published the following chart several times in multiple newsletters. Longtime subscribers have seen it dozens of times before. But... I doubt even they understand why I've published it so often or why I ascribe so much importance to what it tells me.
This chart shows you the "spread" – the difference in yield between U.S. Treasury bonds and noninvestment-grade corporate bonds. In plain English, this shows you what investors, on average, are demanding in extra yield in order to hold junk bonds instead of sovereign bonds...
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 grasp 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 2% 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 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.
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 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 very best time to invest in junk bonds is during a crisis. That's when it's really worth it.
Regards,
Porter Stansberry
Editor's note: On Wednesday, December 6 at 8 p.m. Eastern time, Porter is going live on air to share what he's calling "our most lucrative discovery ever." This is a radical way to potentially double your money in the next 12 to 24 months. Save your seat right here.