Why the Coming Default Cycle Is a Great Opportunity for Speculators

Editor's note: The credit-default cycle Porter has predicting is just around the corner... and it's a speculator's dream come true.

In today's Masters Series, we're featuring an edited excerpt of a recent conversation between Porter and Palm Beach Research Group co-founder Tom Dyson. In it, they discuss how Porter came up with "The Dirty Thirty"... how to maximize your profits as these companies default... and how much of your portfolio you should allocate to this strategy...

Why the Coming Default Cycle Is a Great Opportunity for Speculators
An interview with Tom Dyson, co-founder, Palm Beach Research Group

Porter Stansberry: Tom, thanks very much for coming in to talk about my new product, Stansberry's Big Trade.

This isn't just a product, though, because really this is going to be a historic event in the financial markets... I want to make sure people understand everything we've done.

Tom: Start me off... There's a universe of companies that you begin with. That's 30?

Porter: Right. It's called "The Dirty Thirty."

Tom: How do you filter out to get those companies?

Porter: We started with a credit-research product that has invested in high-yield bonds. It's called Stansberry's Credit Opportunities.

To build out this product, we started with all of the corporate-debt securities that trade in the United States – about 40,000 separate issues. We boiled that down to about 4,000 major issues that are liquid enough and big enough to trade. Then, we assigned our own credit ratings to all of those different bonds.

We can compare our ratings with the major credit-rating agencies. And 97%-98% of the time, our ratings line up... But when they don't, there are opportunities to buy. When we're finding these credits that we see as being very attractive, we also find situations where our ratings are much lower than what the major credit-rating agencies have issued.

This is a way of using our knowledge of the credit markets to make big profits in the event of a default in the equity side of the trade...

More than 45% of GDP has been issued in corporate debt by corporations. That's not safe. That is bubble proportions. We also know, timing-wise, that when the high-yield bonds begin to default at a higher and higher rate... it reaches a tipping point. That tipping point, historically, has been a 5% default rate.

In August, we saw the default rate reach 5.3% for the high-yield bonds. So we know now that we're at the start of a new credit-default cycle.

As the default cycle goes higher, people begin to pull in the credits. They become very leery about issuing new debt. Well, that's right when businesses are going to need it the most. As the default rate goes up, liquidity dries up... And that causes more and more companies to default because they can't roll over their debts.

Tom: A classic circle of death.

Porter: Exactly. It's the default cycle... It's like there's a really long fuse, and that fuse has been lit since 2014. The default rate has been trickling higher, trickling higher, but once it hits that over-5% threshold... the bomb explodes.

In the fourth quarter, I think we'll see a huge increase in corporate defaults. You'll also see a big reduction in new debt issuance. Those will be the next signs that we're on the right track with this approach.

Tom: OK, so we've got the timing. The next two questions are basically: What companies are going to go the biggest? And how do we make money from it?

Porter: We wanted to find companies where we know their existing credit ratings are wrong. We also really wanted to find companies that we know their business model can't survive a default.

Let's say they have so much debt outstanding, like Ford Motor. Ford has to refinance half of its outstanding debt in the next five years. Well, if the junk-bond market is closed – if there's no issuance – and it gets downgraded from "BBB" to "BB"... it won't be able to issue new bonds. It'll be in a bailout scenario, and the equity value – like General Motors – will go quickly to zero.

If you look at the companies we've selected, we call it "The Dirty Thirty." We got that idea from the Dow Jones Industrial Average.

That's 30 of the strongest companies in America. Well, these are 30 of the weakest. As a group, they have $300 billion in outstanding debt. But over the last 10 years, collectively, they've produced negative $10 billion in operating cash profit.

They simply do not have the earnings to support this debt. Therefore, it's only a matter of time until they default.

Tom: The only way they're able to keep paying the debt now is by rolling it over. But as the credit cycle tightens, they won't be able to.

Porter: There's no doubt that the majority of these companies will default during the next credit-default cycle. We've begun that process... And that process will culminate over the next 36 months.

You're going to see that default rate go from 5% to 15% to 20% in the high-yield bonds. Most people don't worry about investment-grade debt, but they should in this cycle.

They have a huge amount of equity value. These companies, as a whole, are still worth more than $200 billion. So we have a huge opportunity to make a profit as that equity value goes to zero.

The lowest-rated group of investment-grade bonds is "BBB"... And normally, "BBB" makes up a very small amount of the total of investment-grade issuance. Generally speaking, it has been less than 10%... Now, over the last 10 years – because of the amount of inflation, because of the government manipulation of the bond market – that little tranche of the investment-grade-credit world has grown to be more than 30% of the outstanding market.

The default cycle got cut short in 2009 and 2010 because the government came in and guaranteed all the bailouts. But the last real credit-default cycle was in 2002. In 2002, 1% of the "BBB" credit defaulted.

You're going to see the "BBB" default rate during this cycle reach junk-bond-like proportions. It's going to be 5% or 10% of the "BBB" defaults. That amount of damage in the credit world is going to be severe... That's what really gives us a huge opportunity... by focusing now and positioning ourselves short these weak Dirty Thirty credits.

Tom: So you have 30 companies that are going to be in horrible financial straits over the next 36 months. And you're going to buy puts on them.

Porter: Right. We're going to position ourselves to make a whole lot of money if these companies get into the credit trouble that I suspect is inevitable for them.

We're not interested in companies that are going to see their stock prices go down 20%. We're looking for companies that are going to default on their debt... because those will actually go to zero.

And as you know, I've got some experience in finding companies that go to zero. During 2008, we wrote famously that Fannie Mae and Freddie Mac would go all the way to zero. And General Motors as well. We have a history of being able to do this accurately.

But the important thing is, you could make a heck of a lot more money on a stock that's going to zero than you can on a stock that's just going to go down 10% or 20%. That's because you can buy what's called an "out of the money" put option. You can bet that the stock price of Ford is going to go below $5. Not just go down a little bit, but go from $12 all the way to zero. You can really make a lot of money by buying a put.

With these trades, we're setting up to make at least 20 times our money in each individual position.

Of course, I don't want to give anybody any kind of outrageous false hope. I personally believe I'll be able to make more than 10 times my money with this strategy. I think that our track record in this product will be very similar to that – eight to 10 times our money I believe will be the average return for all of our trades.

Tom: How many positions should I have in my portfolio?

Porter: What I suggest that you do is stagger... because the timing is very difficult.

Each of these companies have debts that are going to come due at different times. You want to first look to find out when they're going to have a big repayment, and of course, we'll do all of that research for you. You want to trade those guys first.

It's really important that you buy the puts now, not later, because the prices of these puts will go up long before the company actually defaults. You have to establish a handful of positions now.

This credit-default cycle will be unlike anything you've witnessed in your lifetime... where something like 40% of all outstanding junk bonds default, or something like 5%-7% of all investment-grade bonds default.

I've been calling this process "the greatest legal transfer of wealth in history" because enormous amounts of people have made bad loans. Those people are going to suffer losses. But you can take the same exact ideas and convert it into wealth for yourself in two ways: You can buy put options on the equity and you can also wait until the crisis reaches a peak and buy the bonds that won't default.

It's a really exciting time to be an investor, especially if you have the capacity for speculation.

Tom: What percentage should I put in and how much money should that be?

Porter: It depends how you're positioned. If you own a lot of things that are credit dependent, like real estate that's mortgaged or a business that has a heavy debt load... you've got to be really careful. On the other hand, if you don't owe any money and you have a $1 million equity portfolio, this is a great opportunity for you...

In any case, I don't think anyone should put more than 10% of his portfolio long put options. You just can't allocate more than that. And you don't have to... Because if this works, it's going to work really big. That's how I would suggest you play this.

Now, if you're a speculator and you're looking for a way to make a heck of a lot of money... this is your best opportunity in decades.

Tom: Is there a minimum amount that I could do this with?

Porter: Well, you know, the research itself is expensive. We're charging $5,000 for this product. It has a five-year duration because that's how long we expect this entire cycle to take from start to finish.

I think you'll see the hottest years for these trades are going to be in 2018 and 2019, but you have to establish them in 2017. You've got to get into these before the put prices rise.

The puts are really cheap. We're buying puts for less than $1 in most cases, so you don't have to have much money to do these trades. But you do have to be able to afford the research. So if you're spending $5,000 on research, I'd say you have got to have at least $20,000 set aside in risk capital for these trades.

Tom: Cool. I'm excited. I'm going to go and put some of these on.

Porter: Thanks for your time today, Tom.

Tom: Thank you, Porter.

Editor's note: We are on the precipice of an opportunity where betting against the biggest and most indebted companies in the U.S. could lead to life-changing profits. Porter is hosting a FREE live event on Wednesday night where he'll lay out all of the details. Click here to reserve your spot.