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Weekend Edition

The Best of The S&A Digest
Saturday, September 27, 2008

From a reader: Please explain why now is the time to buy corporate bonds, as you recently asserted, while referring to Mike Williams' newsletter for reference. It seems to me that interest rates have to rise from here, given the government's profligate borrowings and bailouts...
 
One of our newsletters, True Income, focuses exclusively on the lowest-rated corporate bonds, so-called "junk" bonds. These securities, or as we've coined the phrase, "guaranteed investment contracts," trade at a substantial discount to their face value – the amount of money they're worth in cash at maturity. The bond market is discounting these securities because investors fear the bonds will default. So while they may have a redemption value of $1,000, you can buy these bonds between $600 and $800 – or even less.
 
But... isn't that risky?
 
There's certainly no such thing as a risk-free, high-yield investment. But in this case, our analyst, Mike Williams, first determines whether the bond in question could be paid off in liquidation. That is, with these bonds, we feel confident our investment is safe, even in the event of a default or a bankruptcy. Plus, unlike when you buy a stock, when you own a bond, the company has a legal obligation to pay you back your investment on a specified date in the future. That's why we call these bonds guaranteed investment contracts.
 
The set-up reminds us of the famous line in the gangster movie, Goodfellas. Discussing debts owed to the mob, one gangster explains there's no alternative, no matter what happens, to repaying the debt. "Business bad? F--- you, pay me. Oh, had a fire? F--- you, pay me. Place got hit by lightening? F--- you, pay me." The same is true for bondholders. No matter what happens, the company must pay you back or liquidate all of its assets... and then pay you back.
 
That's why as these bonds approach their maturity date (almost all the bonds we cover will mature in less than five years), the discount from their redemption value disappears. And while you wait to cash in the capital gain, you will receive coupon payments through the duration of your investment.
 
Let me explain how this all works using the real numbers from our existing recommended portfolio. The average recommended price of the bonds was $720. Thus, on average, we expect to make a 38% capital gain on these securities upon maturity. These securities are also paying a cash coupon now of more than 10% per year. When you combine the capital gain and the coupons, you have a portfolio that should earn nearly 18% per year.
 
That's far more money than just about anyone earns in stocks. And you're not taking the risk of owning a stock, which could be worth zero. Instead, you own a security that companies are legally obligated to repay.
 
You asked about rising interest rates. The high yield and the decaying risk premium as the bond approaches maturity mean these securities face essentially no interest-rate risk. The market for these bonds isn't interest-rate sensitive.
 
What moves the market for junk bonds? The perception of default risk.
 
When investors get scared that lots of businesses will go under, the spread between the yields on junk bonds and the yields on government bonds will increase. That's the time to buy. It may seem counterintuitive, but it's a contrarian strategy that works. You're getting the bonds at a super-cheap price, which more than compensates you for the risk you're taking.
 
As you can see in the chart below, the risk spread between junk bonds and government bonds has rarely been higher than it is right now. Specifically, the previous high occurred on October 10, 2002, when it rose to 10.6%. Earlier this month, it reached 8.9%, a point that's likely to be the high – or very near the high – for this cycle.
 
The Risk Spread Nears Its October 2002 Peak 
 
 
Finally, as with stocks, which bond you buy matters.
 
Most individual investors don't buy individual bonds because they don't know anything about how to evaluate the risk of default. That's what we're providing in True Income. Mike Williams, our analyst, is 62 years old. He has spent his entire professional life analyzing bonds. He is the only Chartered Financial Analyst on our staff. I have total confidence in his ability. I know you will too once you've read his newsletter.
 
Right now, we're offering a risk-free lifetime subscription to True Income – plus our two best stock-based income newsletters – for the price of a single year's subscription. Click here to get the details.
 
Regards,
 
S&A Research




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