Five Steps for Avoiding Credit-Market 'Bombs'
Editor's note: It's an exciting time to be a distressed-debt investor...
According to Stansberry's Credit Opportunities editor Mike DiBiase, the next crisis is just beginning. Corporate-bond prices will likely get much cheaper in the coming months. He believes you could see some of the best opportunities of your lifetime.
But in order to make a killing, you need to avoid the "bombs" in this market.
So in today's Masters Series – adapted from the April 22 DailyWealth – Mike walks through how to evade these hidden dangers to help you build the ideal corporate-bond portfolio...
Five Steps for Avoiding Credit-Market 'Bombs'
On a quiet Tuesday night in Germany, a 1,100-pound bomb exploded... killing three men.
This wasn't a terrorist attack. The active bomb had been buried for nearly seven decades.
You see, the three victims were experts on disposing of World War II-era bombs. Reports said they had defused more than 600 bombs in their careers. But as the head of the Hamburg Ordnance Disposal Unit told German public television at the time... accidents happen.
Old, unexploded bombs remain a major problem throughout Europe. Working near such danger is a risky proposition, even for the best-trained experts. They know most of the bombs will eventually explode... They just don't know exactly when.
For years, I've seen a similar dynamic in the corporate-bond market...
Fueled by a decade of record-low interest rates, U.S. companies amassed trillions in corporate debt. And the credit quality of much of this debt has completely degraded.
I knew a recession or geopolitical shock would eventually hit and blow up the weakest and most leveraged companies... It always does.
Now it's here. I don't want you to be one of the victims of this financial crisis. I want you to profit from it...
As I've shared recently, savvy investors find fantastic opportunities to profit during a crisis. They find them in the corporate-bond market, using the distressed-debt strategy we use in our Stansberry's Credit Opportunities newsletter.
But to be successful, you need to know how to stay away from hidden dangers in this market. So today, let's discuss what you should do to build your ideal corporate-bond portfolio...
First, stay away from corporate-bond mutual funds and corporate-bond exchange-traded funds ("ETFs"). Investing in these funds is not like investing in individual bonds. You'll end up with lower returns while taking on more risk. Here's why...
These ETFs can't choose to hold their bonds until maturity – which is the date that bondholders should receive their principal payments.
When corporate defaults start to rise, investors will want nothing to do with high-yield – or "junk" – debt. They'll want to get out of these funds in large numbers... And the ETFs will be forced to sell their bonds to meet customers' redemptions. They have no choice.
Even worse, the fund managers will likely sell their best bonds first... the ones with the most liquidity that can raise the most cash in a short period. That means the ETFs will be left with a portfolio of ever-riskier bonds whose prices have collapsed. Eventually, there won't be nearly enough liquidity to handle all the redemptions.
Investors in these high-yield ETFs will be wiped out quickly. Don't make this mistake.
Second, build your cash stockpile. It's OK to sit on the sidelines and wait for the best opportunities to emerge.
Right now, there are some good deals out there. But soon there will be much better – and many more – opportunities.
The best high-level way to gauge the number of bargains in the corporate-bond market is by looking at the high-yield credit spread. It's the difference between the average yield of junk bonds and the yield of similar-duration U.S. Treasury notes.
The spread's long-term average is around 600 basis points ("bps"). When the spread is above this level, you'll find the most distressed-debt opportunities. The higher the spread, the more opportunities you'll find... and the higher the potential returns.
Over the past four years, the spread has averaged around 400 bps. But since the coronavirus became a global pandemic, the spread spiked to more than 1,000 bps briefly at the end of March... and then narrowed to about 800 bps. Take a look...
I don't expect this spread to continue narrowing. As I explained yesterday, the number of defaults is expected to rise dramatically this year... to levels not seen since the last financial crisis.
Credit-ratings agency Standard & Poor's (S&P) believes the high-yield credit spread will soon approach 1,600 bps. I expect it to go even higher than that... During the last credit crisis back in 2008, the spread peaked at 2,200 bps. Corporate debt is 75% higher today. I expect this credit crisis will be much worse.
As the credit crisis unfolds, you'll be able to pick up bonds for pennies on the dollar. But you don't want to act until you know a distressed bond is safe – unfairly punished by the market.
Third, only put your money to work in safe distressed debt with attractive returns given the level of risk you're taking on.
That's where my colleague Bill McGilton and I come in... We do all the work for you in Stansberry's Credit Opportunities. Bill is a former corporate lawyer. And I'm an accountant with many years of experience in corporate finance.
We look for businesses that most investors have given up on... but that still produce solid cash flows. The businesses might not be great, but we consider their bonds to be safe. When looking for a bond, we only care about one question: Can it pay us?
To answer this, we look at two things: Whether the company can afford the annual interest costs on all of its debt... and whether it will have enough cash on hand to pay off our bond at maturity.
Fourth, diversify your bond portfolio across at least 10 positions. Understand that investing in distressed debt is risky. Despite all the homework we do, in the end, companies and banks are run by humans operating in a competitive, fluctuating economy.
Management teams can act in their own best interests in ways we may not anticipate. And we can't predict the future or control every variable.
In the long run, you should expect some of your bonds to default. But if you're well-diversified, the large gains in your other positions will more than offset the few losses you endure.
And in the end, you can still vastly outperform the market...
Since launching our newsletter in November 2015, for example, we've closed 26 bond positions. Only two recommendations have defaulted, and our average loss on those two is around 50%. We've booked 21 winners for an 81% win rate. And our average annualized return across all closed positions is 17%. That's nearly double the return of our benchmark – the iShares iBoxx High Yield Corporate Bond Fund (HYG) – in the same holding period.
This includes individual bond annualized gains of 86%... 79%... and 68%.
We've even beaten the stock market. You would have earned only 15% per year if you had invested in stocks instead, as measured by the SPDR S&P 500 ETF Trust (SPY).
For the fifth and final step, try not to be too exposed to any single market sector. In our Stansberry's Credit Opportunities portfolio, we've focused on attractive opportunities in many sectors, including energy, commodities, retail, travel, technology, and finance.
2020 promises to be a tumultuous year...
The COVID-19 pandemic is a true "black swan" event. But if it weren't the coronavirus, something else would have eventually caused a recession and popped the corporate-credit bubble.
Companies already saddled with large amounts of debt are taking on more by the day. And as credit tightens, we'll see these debt bombs begin to detonate – the weakest and most volatile first.
If you follow these five steps, you can build your ideal bond portfolio that will deliver equity-like returns, with far less risk than investing in stocks. Buying high-quality corporate bonds at incredible discounts is a strategy wealthy and sophisticated investors employ.
If you join us with Stansberry's Credit Opportunities, you'll be far ahead of most investors when disaster strikes.
Regards,
Mike DiBiase
Editor's note: If you're now ready to avoid all the credit-market "bombs" and build the ideal corporate-bond portfolio, we urge you to listen to one of our longtime subscribers...
Thanks in part to the type of research Mike does in Stansberry's Credit Opportunities, he retired at age 52. And now, he's weathering the coronavirus crisis without losing any sleep.
While "sheltering in place" in his New York living room, he recorded a short video to reveal all the details. But don't delay... We're pulling it offline TONIGHT at midnight Eastern time. Watch this subscriber's urgent message right here.