The Bitter End

The Bitter End
By Porter Stansberry, founder, Stansberry Research

Still with us? Still reading? You deserve a medal!

Over the last five days, we've published more than 20,000 words about the most boring subject on Earth. It's hard to believe we have any subscribers left...

Let me apologize for torturing you with an unrelenting discussion of corporate bonds. I did it because I genuinely believe that a diversified portfolio of corporate bonds offers the best attainable investment performance for most people.

Most people have a hard time making money with stocks. Most people have a hard time losing money in bonds. As a result, most investors would be better off if they only invested in bonds and never bought stocks. That's a hell of a thing for an investment newsletter writer/publisher to say, but it's true on average.

If you've always had trouble making money with your stock portfolio – or if you would simply prefer a safer and less volatile investment strategy, try allocating more capital to corporate bonds.

When you buy bonds...

And then there's the credit cycle...

There are routine cycles in the corporate-bond market. Just like Joseph warned the Pharaoh, credit-growth cycles (years of plenty) tend to last between six and eight years. These are periods of strong bond issuance, when it's easy for companies to borrow and refinance their debts.

Just as night follows day, these periods are always followed by periods of rising defaults (famine). These default cycles typically last two to four years and feature sharply higher interest rates and much lower prices for corporate bonds.

Credit has been growing strongly for six years now and has only recently begun to tighten. The default rate suddenly doubled, and credit is getting significantly more expensive for the first time since 2008. It seems likely that we are on the verge of a new default cycle, during which great opportunities will emerge in corporate bonds.

One of the main drivers of these opportunities will be large institutional investors, like mutual funds, which can be forced to sell because of investor redemptions. Institutions are generally not allowed to buy noninvestment-grade debt, and many are not allowed to even own it. As a result, when investment-grade corporate debt is downgraded, there can be incredible inefficiencies in the market... Everyone is selling, but no one is buying.

Because the amount of credit growth over the last cycle has been so huge, and the general leverage in the financial system is so high, there are sure to be some huge "fireworks" as this cycle progresses. I fully expect to make dozens of unbelievable recommendations in the corporate-bond market over the next 36 months. When I say unbelievable, I mean it. You will not believe the opportunities we will find.

I recall in February 2009, Steve Sjuggerud showed me a PIMCO leveraged bond fund that was trading at half of its net asset value. If the fund merely liquidated, we would double our money. It was yielding more than 20% at the time, and I couldn't imagine a scenario where we could lose money. These are the kind of nutty things that happen at the bottom of a credit cycle. I hope you'll join me in putting some capital aside and doing some homework now so that we're ready as the cycle progresses.

Let me remind you about what I believe is the greatest advantage over stocks that bonds offer investors...

It isn't true that as the price of a stock declines, it becomes less risky. Value investors love to sing that song, but it's a lie. Most stocks that dip below $10, for example, never go back above that price. Share prices fall as a company's prospects decline, or as their balance sheet becomes encumbered. Often, the problems get worse as the stock goes lower. Thus, a falling stock price is normally a harbinger of trouble and more risk. If you've ever bought a stock that looked "cheap" and then got a lot cheaper, you know what I mean.

Bonds, however, are binary. The intrinsic value of a bond doesn't change, regardless of if the company is doing well or poorly. The security of a bond lies in its underlying collateral, not in the performance of the company. Therefore, a bond that's trading at $25 can be genuinely less risky than a bond trading at, say, $75. Yes, the $25 bond is more likely to default, but that isn't the same thing as saying it's riskier.

In fact, one of the most striking facts we've discovered about bonds during our research is that noninvestment-grade bonds and investment-grade bonds have had almost exactly the same recovery rates over the last 30 years – around $0.40 on the dollar. While I would not expect recoveries to be that good during the next default cycle, when we recommend bonds we will always evaluate the collateral so that we know what we are actually risking in a worst-case scenario. With stocks, you're always risking 100%.

I believe discounted corporate bonds offer investors an unbeatable combination of high returns and safety. With these bonds, you have the opportunity to make capital gains that are better than the average returns in stocks, while also earning high rates of current yield. Plus, you can make these returns with securities that are far safer than stocks.

There are, of course, huge caveats to this advice.

I've tried to explain most of the pitfalls over the last five days. The biggest and most important caveat is that, unlike stocks, bonds are binary. They will either pay you in full and on time or they won't. That's great because you don't have to worry about whether the company is doing well, you just have to make sure that it can pay you. This creates a different kind of market dynamic where, if doubts about a company's ability to service its bondholders emerge, it can become difficult (or even impossible) to sell.

The only way to deal with this kind of binary, do-or-die asset is to diversify your portfolio. If you're not able or willing to diversify your corporate-bond portfolio – that means buying at least 10 different bonds across the risk spectrum – the chances of you losing money are 50/50.

On the other hand, if you diversify and wait until these bonds are trading at a substantial discount to par, there is almost no chance you will lose money if you're able to hold the bonds until maturity.

The other major caveat is that bonds can be difficult to buy and sell. Unlike stocks, there isn't a constant bid and ask in every corporate bond. When you want to buy, you usually have to pay a much higher price than you could get if you wanted to sell.

This "spread" makes trading bonds a bad idea for most individuals. That means when you buy a bond, you have to be prepared to hold it. It also means trading techniques that you might use to manage risk will be much less effective. That's another reason diversification is so important.

I've spent a lot of time and money over the last 12 months building a huge analytical engine that can analyze all U.S. corporate bonds. Our system is designed to find the "needle in the haystack" – bonds at various levels of risk that we believe are mispriced relative to their chance of default.

I'm confident that with this new tool and my team of analysts, we can outperform the work we did during the last default cycle, when interest rates on these kinds of corporate bonds peaked in the mid-20% range. This is going to be a fantastic time to be a bond investor. And we've built the tools you need to make careful, diligent choices. I wouldn't buy bonds without looking at our work first.

Yes, we will be making specific recommendations – probably one per month. But far more important, we're also going to give you a fair amount of data on the market and individual bonds that our computer models have told us are attractive. This will help you time the default cycle and give you dozens of possible bond investments in addition to our formal recommendations.

But let me say this: I firmly believe our new Stansberry's Credit Opportunities advisory will be the most successful and safest advisory we have ever published.

Sure, it's easy for me to say that. But look at the performance of the bonds we recommended during the last crisis... we didn't lose money on any of the distressed bonds we recommended, from Lehman's default through the end of 2010, and one of those bonds made returns in excess of 700%.

This coming default cycle will be worse, and the tools we now have to pick safe bonds are far better and more sophisticated than what we had last time. I have heard from hundreds of you that wished you had paid more attention to our last bond newsletter. Well, this is it. This is opportunity knocking. Don't fumble the ball this time.

Here's the irony: Even if I'm right about the future performance of this product – even if it's the most successful advisory we ever publish – it will also generate more subscriber anger and dissatisfaction than any of our other publications.

Why? Because buying bonds is not like buying stocks. You will probably have to use the phone. Some brokers will not allow you to buy noninvestment-grade bonds. Some brokers will not help you find the bonds you want to buy. That's why I strongly suggest you call your broker and discuss your plans to buy distressed bonds during the next 12 to 36 months. Find out if your broker is willing to work with you and, if he isn't, find one who will. It's not that hard.

You can do it. And it could be worth a fortune if you just try. According to many subscribers, Interactive Brokers is easy to work with and is prepared to help you purchase individual bonds. I personally have used TD Ameritrade to buy deeply distressed debt. It's not impossible to buy corporate bonds. It just might feel that way the first time you try. Persevere.

Here's something you've never seen me do before: There are a lot of reasons you shouldn't subscribe to my new bond letter. I want to make sure you understand why it's probably not right for you...

• Please do not subscribe to our new bond service if you're afraid of using the phone or if you can't be bothered to search for a good bond broker who will work with you. Remember, we cannot recommend a broker. We cannot place your trades. We cannot give you any personal advice whatsoever.
• Do not subscribe if you can't manage dealing with nine-digit CUSIP symbols that are made up of both numbers and letters. (Oh, the horror!) This is how bonds are identified. You will have to use them every time you buy or sell a bond. You will see them every time you get your account statements. And you will see them constantly in our research.
• Do not subscribe if you're not aware that there can be little liquidity in the bond market. When we make a recommendation, our subscribers who buy will cause the availability of those bonds to decrease, at least temporarily. That doesn't mean you will never be able to get the bonds you want, it just means you have to be patient. You might have to consider buying a slightly different bond (from the same issuer). It's no big deal, as our ratings are based on the issuer. But if you can't handle being flexible given the liquidity constraints of this market, do not subscribe to this advisory.
• Do not subscribe if you're only going to buy the riskiest bonds we recommend or if you're not willing to diversify your portfolio. Please, please, please do not do this. It will make me pull out my hair when you send me a note blaming me for your losses.
• Finally, do not subscribe if you're poor. I'm not being rude. I'm serious. Bonds are great for people who are already rich. They're not that great for people who are poor, as most of the returns from bonds come from coupons (yields). To earn good amounts of income, you have to have a lot of capital. That's just a fact, and it's not my fault. When asked about the poor, Ayn Rand said "Don't be one of them." I subscribe to the same theory. Go make money. When you have some, subscribe to our bond research. But please don't badger me about not doing enough to help people: I just wrote more than 20,000 words about bonds, for Pete's sake. And I didn't charge you anything to read them.

Regards,

Porter Stansberry