Why Great Investors Focus on Bonds, Not Just Stocks

Why Great Investors Focus on Bonds, Not Just Stocks
By Porter Stansberry, founder, Stansberry Research

Today we continue with our five-part series on bonds...

And there it is: the digital stampede away from this letter. I can hear people groaning and clicking away. "Not again," they'll say. "When is Porter finally going to shut up about bonds?"

Dear subscribers, we are almost finished. This is part three. There are only two more days of this stuff. Hopefully you survive.

Let's start with something that few stock investors realize. This is a bona fide secret that probably no one has ever told you about buying stocks: You should NEVER buy a stock until you know where a company's bonds are trading. I'll explain why in today's Digest.

You see, this series of essays isn't about safe, boring bonds, like sovereign bonds, or "muni" bonds, or even super-safe AAA- or AA-rated corporate bonds. No. Our focus is on noninvestment-rated corporate bonds. These are the bonds the attractive people on TV call "junk bonds."

These are not the promises of governments or municipalities (which have the power to tax in order to fund their bond payments). These are not bonds created from prime mortgage payments, which, if properly underwritten with substantial down payments, have traditionally been extremely safe, too. These are not even the bonds of large, successful corporations, whose promises to pay are rarely discounted and whose bonds rarely default.

No, our focus is on the promises of smaller, higher-risk corporations. During a crisis, around 15% of the outstanding bonds in this category will default each year, making these bonds far too risky for most institutional investors.

Why would we want to focus on an investment class that the people on TV label "junk"? Why would we be interested in the promises of corporations that may or may not be able to pay? Why on Earth would we want to buy bonds that we know have a real risk of defaulting?

Because the returns you can make in junk bonds are even bigger than what you can make buying stocks. And you can do so with much less risk. Bondholders – even junk bondholders – have far more rights and protections than shareholders...

That's why I tell people that if they knew much about discounted corporate bonds, they would never buy stocks again. At the very least, you should always know where a company's bonds are trading before you buy its stock.

Any time the bonds are trading for a significant discount to par, you should know that buying the stock is risky and probably stupid. You're going to end up either having your investment diluted or holding a stock that goes to zero. The bondholders will be laughing at you either way.

No, not every discounted corporate bond will offer such large returns. Not every discounted bond will avoid default. There are risks to investing in these securities. But it isn't nearly as risky as buying stocks.

The simple truth is that most individual investors are completely ignorant about the opportunities in bonds. They simply don't understand them. Meanwhile, almost every great investor – Icahn, Buffett, Kalir – specializes in understanding the entire capital structure of a business. They look for places where their capital is going to be treated best and is going to be safe. Sometimes that means buying stocks. Sometimes that means buying bonds.

For investors who know something about bonds, there are still two big hurdles that prevent a lot of people from dealing in them. I can help you mitigate these problems, but I can't make them disappear completely. You need to know about these hurdles in advance.

One major problem for bond market investors is liquidity. Bonds don't trade in the same volume that stocks do. As a result, you can't buy or sell corporate bonds instantly in most cases. It can take a week or two – sometimes longer – to fill a large position.

Prices can increase, sometimes dramatically, when you try to buy. Prices can fall, even by absurd amounts, when you try to sell. And these problems have gotten worse recently because new rules make it difficult for banks to profitably make a market by holding an inventory of bonds. How do you deal with this liquidity problem? You have to be patient and you have to be willing to shop around.

You might have to call more than one broker to see if you can find the bond you're looking for in their inventory. You might have to wait for a day or two while they call around to other brokers on your behalf, looking for someone who is willing to sell. The important thing is to have a range in mind that you're willing to pay – don't be bullied up too much in price – and then you simply have to be willing to wait.

Another solution is to consider buying another bond that has been issued by the same company. You could buy a slightly different bond – one with a different maturity date, for example. Or look at our research (which I'll show you tomorrow) and find a bond from another company that has the same rating from us and offers a similar return profile.

One of the best things about new research products is that, much like our Stansberry Data service, we'll show you all of the bonds that we think are outliers – bonds that we think should be more appreciated by the ratings agencies and the markets.

If you have seen our Stansberry Data Insurance Value Monitor, you should be familiar with this approach. In Stansberry's Investment Advisory, we tell you exactly which property and casualty insurance stocks you should buy right now, and we maintain a model portfolio for you in our newsletter. But in Data, we show you the entire sector and our ranking of every single property and casualty company in the U.S. and Bermuda.

It's a piece of cake to understand why we've recommended the stocks we have in our portfolio. And it gives some insight into which companies we may recommend next.

Another major hurdle for stock investors is the fundamental difference between stocks and bonds. Because of the binary nature of bonds, there's no middle ground. There aren't any bonds that "do OK." They either perform, or they default. That's radically different from investing in stocks. It can be difficult for investors to understand and adopt strategies based on these binary outcomes, the most important of which is diversification.

You may not be able to sell bonds that go bad, because once that negative binary outcome (default) becomes more of a possibility, no one will buy the bonds you hold. That means trailing stops can be much less effective. The only way to limit risk is to limit your position size. In my experience, many investors simply don't understand that this is the single most important component to bond investing. No matter how many times I explain it, they refuse to diversify.

You can get away with a concentrated portfolio in stocks if you rigorously cut your losses. But there isn't enough liquidity in the bond market to do that... And the binary nature of bonds' outcomes means you're nuts if you try.

Remember: The only safe way to succeed is to buy a portfolio of bonds in a diversified manner – not all from the same industry and not all concentrated in the highest yields (the riskiest bonds). The rewards for this approach are truly magnificent, as you will see, but most people can't do it. They lack the discipline.

Finally... the hardest thing for stock investors to understand about investing in bonds is that great opportunities only emerge during periods of financial stress. The upside in bonds is usually limited to $1,000 per bond. Sure, there are exceptions. Convertible bonds can become shares of stock, in which case there is no set limit to price.

But for the majority of the bonds you buy, you will not receive more than $1,000 in principal when you sell. That means when you buy and how much you pay determines how much you will make. In bonds, even more so than in stocks, you must buy when prices are depressed.

Without the crisis, there isn't any opportunity.

It's hard for people to get their heads around the idea that there will be a major crisis in the bond market over the next three or four years... and that's why I've relaunched a bond newsletter.

You should be buying bonds during this crisis. They're different from stocks. They're safer. They have binary outcomes. And other investors don't like to own them when they are distressed. That's what makes a crisis in the bond market different from a crisis in the stock market. I know that most of you will never be able to understand this concept... and that's OK. It's not easy to understand.

As I always do, let me sympathize with the majority of you who simply have no desire or ability to learn something new – especially not about money. British philosopher Bertrand Russell explained better than anyone before or since why it is so difficult for people to learn new things...

We all have a tendency to think that the world must conform to our prejudices. The opposite view involves some effort of thought, and most people would die sooner than think.

Learning new things, especially things that challenge your preconceptions, can be excruciating. If this isn't for you... if you find it all too foreign or confusing... don't worry. I'm sure you can live a happy and fulfilling life without a thorough understanding of the corporate-bond market.

What's most likely to trip you up if you try to invest in bonds? The problems with liquidity and the need for diversification are genuinely challenging factors. If you're a good and serious investor, you will find that aspect of bond investing challenging. It shouldn't prevent anyone from being successful, it's just different from investing in stocks.

But a lot of people reading today's Digest will never get close to the real, actual hurdles of investing in bonds. Instead, they will be consumed by the cosmetic differences. You might not believe me, but the biggest hurdle for most people seems to be the telephone. To buy bonds, you will have to use a phone. For many people, that's like asking them to run a marathon. They won't do it. It doesn't matter that the entire script for exactly what to say is printed in our advisory. They can't face talking to a bond dealer.

These people would rather lose money by using a computer to buy stocks they don't understand than make money by picking up the phone. I can't do anything for these poor folks but refund their money and wish them luck. I only regret their unwillingness to learn because I know it's costing them so much opportunity.

Likewise – and this would be funny if it weren't sad – a big problem for a lot of subscribers is the CUSIP code. As I explained earlier, this is the code that identifies each bond. It's the equivalent of a stock symbol. But it's not a few easy-to-remember letters. It's nine digits and letters. Oh, the horror. Nine whole digits.

Again, I'm not kidding. CUSIP numbers send a lot of people for a loop. Nine digits! How can you do this to me? I can't read a nine-digit number! A phone number with the area code has 10 digits, 11 if you add a country code. Nobody seems to complain about that... but for some reason, a nine-digit number to identify a bond just blows their minds. I will never understand it.

Clearly this is madness, trying to teach average investors about corporate bonds. They can't even handle reading a nine-digit number or using a telephone to make an investment! Yes, it is madness. Most people won't pursue this. Many of those who do will completely botch it – mostly by refusing to diversify. They will cancel their subscriptions with my business and say terrible things about me all over the Internet.

So... why do I bother? There's only one answer: I'm an idiot. I know I'm an idiot. But I just can't help myself. I've always written to my subscribers with the intention and the purpose of trying to give you the information I'd want if our roles were reversed. And ever since I learned about how incredibly lucrative buying discounted corporate bonds can be, I've been trying to teach my subscribers how to do it.

It's my passion today because we are approaching a severe credit default cycle. More than $1 trillion worth of corporate bonds will default in the next three or four years. We can know this with far more certainty than anyone can predict the stock market because we know precisely when bonds come due. We know exactly how much interest and principal is owed. And we know, in many cases, that this money cannot possibly be repaid on time.

That means if credit tightens – if investors become more wary and begin to refuse to extend additional loans – these bonds will default. That process has begun because default rates have doubled in the last year, and the cost of credit in the corporate-bond market has begun to significantly increase for the first time since 2008.

Historically, every six to eight years one of these default cycles begins. Typically, between 20% and 30% of all of the noninvestment-grade bonds that are outstanding will default. (Usually about 5% of the investment-grade bonds default, too.)

The key thing to understand is this: The magnitude of the credit given out during the preceding credit boom is what determines the severity of the default rate and its resulting losses in the default cycle.

And the last period of corporate credit underwriting was the most expansive in history. Before 2009, the U.S. junk-bond market never issued more than $150 billion worth of credit in a year. Issuance was more than double that amount in 2012, 2013, and 2014. And while the bond market was issuing twice as much debt as normal, it was doing so with the lowest interest rates and the easiest terms the market had ever seen.

In short, the Federal Reserve's actions to send short-term interest rates to zero had the unexpected effect of forcing investors to buy far riskier forms of debt (like junk bonds) to earn any yield at all.

As a result, by mid-2013, bonds that normally paid double-digit interest rates to compensate for their risk of default were paying less than 5% on average. Since then, the entire market has been like a ticking time bomb as many of these bonds are destined to blow up as soon as credit tightens. And that's what's starting to happen right now.

For most investors, this will be the greatest financial tragedy of their lives – even worse than the losses they suffered in 2008 and 2009. As junk bonds "blow up," they will become nearly impossible to sell.

Bond mutual funds – even the biggest and the "safest" – now own billions and billions of dollars' worth of these bonds. Mutual funds owned almost 20% of all corporate bonds by the end of 2014 (the most recent data available). That's up from just 8% of the market in 2008.

It won't just be one or two big mutual funds that blow up. There are now 10 bond mutual funds that manage more than $40 billion, up from only two in 2010. As credit tightens and riskier bonds begin to fall substantially in price, investors will panic and try to redeem their investments in these mutual funds.

The funds, which are required to provide seven-day liquidity, will be forced to sell something to generate cash. Will they sell a junk bond trading at $0.60 on the dollar and "eat" a 40% loss? Or will they sell an investment-grade bond that's still trading around par? The truth is, they won't have a choice... they will have to sell the higher-quality bonds.

Normally, an institutional investor would dispute that scenario, saying, "We won't sell. We know what we own, we're diversified. There will be some losses, but our ability to hold until maturity means that we don't worry about volatility."

But these mutual funds have to supply daily price quotes to their investors, and they have to provide weekly liquidity. Trust me, when retired investors see their "safe" bond mutual fund is down 20%, they're going to panic. They don't know anything about holding to maturity. They just know the only way to stop the pain is to sell.

And the only way these mutual funds will be able to generate the capital to meet the redemption demands is by selling bonds that are safe and trading near par. They won't be able to sell the distressed bonds. That will cause the value of the funds to fall even faster, spawning additional redemption demands... until eventually there aren't any more liquid bonds to sell. At that point, the mutual funds will have to halt all redemption. The fear of this suspension of redemption rights will also cause many investors to sell – simply because they're afraid of being caught in a sinking ship.

Thanks to the binary nature of bonds, nobody will buy bonds that are in obvious distress. In fact, most institutions aren't even allowed to own them. This combination of a lack of market liquidity, bonds' binary outcomes, the previous weak underwriting standards, and the panic of average investors will cause a tremendous crisis. And it won't just be mutual funds... Institutions of all kinds, including major corporations, have followed mutual funds into the corporate-bond market. There will be enormous "collateral damage" as plenty of financial companies get caught in this mess.

Tomorrow, I'll show you how we've built a massive analytical engine powered by huge amounts of data to help us monitor the entire corporate-bond market in real time. This allows us to find the proverbial "needle in the haystack." We can compare tens of thousands of individual issues and pinpoint which bonds are being "force sold" and thus have prices that are well below where they should be relative to their risk of default. This research will allow us to buy bonds at discounted and attractive prices across the risk spectrum, helping you build a diversified and safe portfolio during the coming crisis.

I'll also give you a handful of indicators that you can use to better anticipate the coming crisis and to measure its growing severity. It isn't hard to see that credit is contracting already. And that means the crisis is coming. I'll show you exactly what to watch for tomorrow.

Regards,

Porter Stansberry