Editor's note: Many of the world's best investors – folks like Howard Marks, David Tepper, and Seth Klarman – are using a strategy you may have never heard of before...

It doesn't involve stocks, options, or currencies. And as Stansberry's Credit Opportunities editor Mike DiBiase explains in today's Masters Series essay, you can start using this strategy to generate stock-like returns with far less risk than investing in stocks...

A Little-Known Way to Capture Stock-Like Upside With Far Less Downside Risk

By Mike DiBiase, editor, Stansberry's Credit Opportunities

It's much, much safer than buying stocks... And in rare instances, it offers the upside of stocks.

In yesterday's Masters Series essay, I discussed the incredibly lucrative – but often ignored – strategy of buying safe corporate bonds at distressed prices (what we're calling "penny bonds"). Let's look at an example...

Let's assume you bought a bond with a 10% coupon for $750 that matures in two years. The issuer is obligated to pay you semiannual interest payments that total $100 each year ($1,000 par value multiplied by the 10% coupon rate), as well as the full $1,000 par value at maturity.

On a purchase price of $750, that's an effective cash interest yield of more than 13% ($100 annual interest payments divided by your $750 purchase price). On top of the interest payments, you'll also book a $250 capital gain at maturity ($1,000 par value less your $750 purchase price). Including interest and capital gains, your total return in two years will be 60% with a much safer investment than stocks.

Compare that to investing in stocks, where your success completely depends on the market. The only way to earn a positive return, of course, is to sell your shares for more than you paid for them. But the stock market is notoriously fickle and impatient, and when it sours on a company, shares can plummet quicker than you can unload them. Any hard-earned gains can disappear overnight.

But when you buy penny bonds, you don't have to worry at all about what the market does next. As long as the company can afford to pay you all of the interest and principal you are owed, your gains are locked in from the start. If the bond price falls, it doesn't matter. As long as you know your bond is safe, you can rest easy. The company has no choice but to pay you. You don't have to worry about its market price.

You know how many interest payments you're owed and when you'll get paid your $1,000 principal. You can easily and accurately calculate your expected returns. In other words, you know exactly what your return will be at the time you make your investment. The cheaper we can buy these bonds, the higher the returns.

With bonds, the only thing that matters is whether the company can pay you.

The key to this strategy is finding penny bonds that are safe.

That sounds easy, but it isn't. Bonds typically only trade far below par value when investors are concerned that the company might default on its debt.

The truth is, most companies whose bonds trade well below par are risky. If a company defaults on its debt, things get messy. Bankruptcy can be a long, drawn-out process.

In Stansberry's Credit Opportunities, we're careful to avoid those types of situations. Every month, we scour through more than 40,000 corporate bonds. For the most part, the majority of bonds are priced correctly. But occasionally, we find "outliers." These are bonds whose prices are much lower than they should be, given their level of safety.

Unlike most bond investors, we don't rely on the major credit-ratings agencies like Standard & Poor's or Fitch. We use our expensive Bloomberg database to crunch through the numbers of the companies that issued corporate bonds and assign them our own proprietary credit rating. We're looking for one thing: Can the company pay us?

When we find bonds that appear much safer than their price and yield suggests, we roll up our sleeves and do even more homework. We analyze the bond issuer's business and competitive situation. And our in-house lawyer Bill McGilton reads through the bond documents and the company's other debt obligations to understand exactly where bond investors sit in the capital structure. He pores through the terms of the contracts and filings to understand your legal rights particular to each bond issue.

So... how have we done so far?

We analyzed our performance since launching Stansberry's Credit Opportunities nearly three years ago. We wanted to know how we performed against the backdrop of where we are in the credit cycle.

The number of safe penny bonds varies greatly depending on the market's general sentiment toward corporate bonds. When investors love corporate bonds (as they do today), bond prices are expensive and their returns are low. When they hate them, bond prices fall and their returns are much higher.

The best way to gauge how expensive or cheap corporate bonds are, on average at any given time, is by looking at the "high-yield credit spread." This is the difference between the average yields of high-yield (or "junk") corporate debt and similar-duration safe U.S. Treasury notes.

When this spread is at 700 basis points ("bps") or higher, the best distressed-debt opportunities emerge. When we launched Stansberry's Credit Opportunities in November 2015, the spread was around 600 bps – its historical average over the past 20 or so years. It was relatively easy to find outliers then. More important, the spread was moving higher...

Shortly after our first issue, the spread surpassed 700 bps. It peaked three months later at nearly 900 bps, then fell below 700 bps in April 2016. It continued to head lower over the following year. Since then, it has bounced between 320 bps and 400 bps. Today, it sits around 337 bps.

Finding outliers is extremely difficult with the spread at its current levels. Still, we've managed to close 16 penny bond positions in less than three years. The graphic below shows the average annualized return you would have earned by investing an equal amount in each of our closed recommendations for three periods...

1. From the launch of Stansberry's Credit Opportunities in November 2015 through April 2016 (when the spread was around 700 bps or higher)
2. From April 2016 through today
3. Over the entire period

The graphic also shows the returns of a junk bond benchmark, the iShares iBoxx High Yield Corporate Bond Fund (HYG), as well as the broad stock market (as measured by the S&P 500 Index).

As you can see, we nearly tripled the returns of the overall high-yield market across all three periods.

Not surprisingly, our recommendations performed much better when credit spreads were high. The average annualized return on our penny bond recommendations was 36% from November 2015 to April 2016. Since then, it has been 20%. That's to be expected. When the spread is wide, it's easier to find outliers in the bond market. And those outliers offer higher returns.

Even more remarkably, we beat the return of the overall stock market over all three periods. And we did this while taking on far less risk than with buying stocks.

We've accomplished these results by carefully selecting only the bonds with the best risk-versus-reward setups. This requires a lot of work, but the results show it's worth it. And we're just as proud of the bonds we didn't recommend as the ones we did. Unlike most investors, we don't "reach for yield." When we can't find any bonds worth recommending, we simply hold on to our cash and wait. Reaching for yield only leads to disappointment.

We're patiently waiting for the bond market to roll over. We're not scared of a bear market in bonds. In fact, we're looking forward to it. A bear market will cause the number of attractive distressed debt opportunities to explode and give us opportunities with massive upside.

In the meantime, we've generated fantastic results, even with spreads near historic lows. This is exactly why investing in penny bonds is an important tool for every serious investor's "toolbox."

Regards,

Mike DiBiase

Editor's note: We've spent millions of dollars building the Stansberry's Credit Opportunities team to find the best penny bonds in the market... including more than $100,000 a year on data alone. The team analyzes more than 6,000 bonds every month to find bonds with stock-like upside... and a fraction of the risk. We just put together a presentation detailing everything you need to know about this little-known investment. You can watch it here.