Saturday, April 2, 2011
Today, we continue on our thankless quest to educate our subscribers. Longtime subscribers are used to these "rants" and won't be surprised to see another.
In my experience, few people are interested in learning anything. Most folks have long since made up their minds about their investing strategies. They don't want to try anything new – ever. And they most certainly don't want to think carefully about what they're going to do next. They subscribed to our paid newsletters because they want a stock tip. They want it to go up. That's what they paid for. And that's all they want. Anything else just confuses the matter, wastes their time... and leads them to demand a refund.
So... why do I keep doing these essays? Well, some things are more important than money. If all I wanted was to maximize revenues, we'd change lots of things about our business. We'd raise our prices considerably, for starters. But there are many ways to succeed in business. The path I've chosen is to always tell you the things I'd expect you to tell me if our roles were reversed. It's what my dad taught me: "Porter, you can almost never do the wrong thing when you're trying your best to do the right thing."
In today's essay, I want to return to our study of the corporate bond market. If you're like our average reader, you've never bought a corporate bond and never will. That could be the single biggest investing mistake you'll ever make.
If I could give my subscribers one thing, it would be an understanding of the corporate bond market. In my opinion, most individual investors should never buy stocks at all (or only very, very rarely). Instead, they should focus nearly all their investments in corporate bonds. I have new data that will help explain why this is true.
If you've never bought a bond before, there are dozens of factors you'll need to learn. And subscribers to True Income have access to our guide to bonds, which explains everything you need to know in one place.
Today, we're going to focus on the one factor that matters the most: the risk of default. Default is what happens when you buy a bond and the company doesn't pay you the interest you're owed or can't pay you back your principal at maturity. When this happens, a company must declare bankruptcy and repay its creditors. The courts oversee the process to make sure every creditor is treated fairly. Keep in mind... while default is the worst possible outcome for bond investors, it's relatively rare. In fact, I believe once you understand the dynamics of these worst-case scenarios, you'll immediately "get it." And you'll probably never want to buy a stock again.
So what is a bond? A bond is nothing more (or less) than a loan, which trades in the form of a security. Corporate bonds usually have a par value of $1,000. That is, at maturity, the corporation must redeem each bond for $1,000. Interest on this debt is paid annually, semi-annually, or quarterly, depending on the terms of the particular bond. These payments are known as "coupons."
Bonds have two enormous advantages over stocks, in my view. First, the bondholder has exceptionally strong legal rights to both his principal and the coupon payments. The holder of common stocks has virtually no legal rights, with dividends being at the discretion of the board of directors. Common-stock holders also sit last in line in the event of a bankruptcy – they usually receive nothing. Bondholders, on the other hand, almost always get a significant portion of their principal back, even if the company goes bankrupt.
The second big advantage is the future return on bonds can easily be judged by almost anyone, no matter how inexperienced. You can look up exactly when a bond will mature. You can easily calculate your precise future return. Thus, investors can know today exactly what they will earn tomorrow. That's crucial for investors who are living off their portfolio returns. It's impossible to know what the value of a stock will be tomorrow, or how much it will pay in dividends.
Moody's – the world's largest bond ratings agency – has kept default statistics on the bonds it rates since 1920. While these statistics don't include every bond ever issued, they do cover the majority of the U.S. corporate bond market. Thus, from a statistical perspective, these records are many times larger than required to constitute a reliable sample.
Over this 88-year period, the 10-year default rate on the lowest-rated, investment-grade corporate bonds (Baa) is only 7%. The recovery rate on senior unsecured bonds from 1987 through 2008 was 46.2%. (Or you can view this as a "loss rate" of 53.8%). That means even if you ended up with one of the seven out of 100 bonds that defaulted, you still ended up getting almost half of your money back.
In other words, assuming none of your other bonds produced any positive return whatsoever, your expected capital loss on a 10-year bond portfolio would be negative 3.7%. You might think of this as the most amount of money you could possibly lose, except that it's a tremendous exaggeration of the downside. It's impossible for the other bonds in your portfolio not to earn a large return. So this negative 3.7% is purely hypothetical.
Still, if you think that's a bit too risky – even as a hypothetical example – you can easily (and dramatically) reduce your risk by simply avoiding any long-duration corporate bonds. The default rate plummets as you move the duration of your portfolio into shorter timeframes. From 1920 through 2008, the default rate on investment-grade corporate bonds from issuance through year five is only 3.1% – less than half of the 10-year default rate. At this duration, your hypothetical maximum loss is reduced to only 1.6%. Again, I stress... this scenario implies the other 96.9% of your bond portfolio earned nothing over five years. That's not just improbable, it's impossible. Bonds are legally required to pay their coupons (or they must default).
These low default rates and high recovery rates are why I say it's virtually impossible to lose money by investing in investment-grade corporate bonds, as long as you do it in a relatively diversified way. And even though you might only earn 5% per year (pre-tax) in investment-grade corporate bonds, that's far more than you'll earn in any other kind of extremely safe fixed-income investment. It's also probably more than 90% of individual investors have earned in stocks over the last decade.
Ah... but what about interest-rate risk, you might wonder. Isn't it true that if interest rates rise (and I believe they will), the value of existing bonds will fall, as new bonds will carry a higher coupon rate? Yes, that can happen. And it is very likely to happen, in fact. But it's completely irrelevant...
Simply holding your bonds to maturity eliminates interest-rate risk. The company whose bonds you buy is required to pay you back at par – 100 cents on the dollar. If between the time you buy them and the time they mature, the bonds trade at a discount to par, their market price has declined – but not their full (par) value. They're still worth 100 cents on the dollar at maturity.
You only take a risk if you trade bonds and sell them before maturity. That's why one of the keys to success in the bond market is holding for maturity, something that Mike Williams, our True Income editor, taught me. Mike intends to hold through maturity most of the bonds he recommends. (Periodically, he'll sell them early if they approach par value long before maturity.)
Now... you may look at those 5% annual returns and think, "That's nice. But it's not nearly enough." You might argue the risks of the stock market are worth it because the returns available are so much larger.
Let's think about that for a minute. The best stock investor ever is Warren Buffett. His long-term compound return in stocks is around 20% annually. I believe Buffett is likely to be twice as good of an investor as most of us. So anyone who can earn 10% a year or more on his entire portfolio is doing a good job.
Please think about what I'm saying. I'm talking about total portfolio returns. Yes, you can certainly earn a lot more than Buffett with some of your money, especially if you're a good trader or you're an expert at small-cap technology stocks, etc. But most people only invest aggressively with a portion of their portfolios, which leaves the majority of their money looking for a home. What I'm suggesting is... for most of your assets... investment-grade corporate bonds are better than stocks.
But that's just part of the story. You see, once you've gotten familiar with how bonds work, you'll discover something I think is one of the great secrets of finance. If you're willing to take a bit more risk in bonds... and spend a little time studying the companies backing these debts... you can earn a lot more money in bonds – without taking on any significant risk.
As I explained, investment-grade bonds have low default rates – so low, they make capital loss nearly impossible. Not all corporate bonds are risk-free. So-called "junk bonds" have higher default rates. The five-year cumulative default rate for B-rated bonds is a little more than 21%. But here's a surprising fact: The recovery rate on B-rated bonds is almost identical to investment grade bonds.
Keep in mind, the junk-bond underwriting market didn't develop until the 1980s. So when studying recovery rates, it's important to pay attention to the years from 1982 through 2008. During that period, the recovery rate (how much money investors got back in the event of a default) for A-rated corporate bonds was 40.9%. The recovery rate on B-rated "junk bonds" was 40.6%. That's virtually the same – you lose about 60% of your investment when these bonds default, on average.
This is a critical anomaly to understand. It's one of the few cases in finance where you can get paid for taking risks that aren't really there. Yes, these bonds will default more often. But they're not actually riskier. Here's why...
Let's say you put your entire portfolio into B-rated bonds, all with five-year maturities. According to Moody's data, you'd expect for almost 80% of these bonds to pay off. Meanwhile, you'd expect 21% of the bonds to default. Again, assuming you made absolutely nothing on the 80% of the bonds that didn't default, your expected loss would be small – only 12.5%.
Meanwhile, junk bonds frequently offer investors vastly higher returns than investment-grade bonds because they pay higher coupons and frequently trade at wide discounts to par. While corporations redeem bonds at 100 cents on the dollar, you can frequently buy distressed bonds for much, much less.
For example, Mike Williams recently recommended a Liberty Media bond that was trading for less than 60 cents on the dollar. When these bonds mature, investors will capture a 66% capital gain, plus all the coupons that have been paid. This dynamic – earning a capital gain on a bond because it is trading at a wide discount – allows investors in the junk-bond market to earn stock-like returns without taking any equity risk. Imagine if more investors understood this opportunity!
Let me show you how powerful this can be. When we launched True Income in 2008, we did so primarily to take advantage of this dynamic. We knew junk bonds, when held to maturity and bought carefully, offered us one of the few legitimate "freebies" in all of finance – the chance to make stock-like gains without taking stock-like risk.
Interestingly, we launched the product just a few months before the worst bear market in corporate bonds since the Great Depression. Roughly 12% of all junk bonds outstanding defaulted in 2008 – an annual default rate that far exceeded our worst expectations. That's why out of 40 recommended bonds, our portfolio has suffered three defaults (a 7.5% default rate). And yet, despite all these problems, Mike Williams has averaged annualized gains of more than 16% a year, according to his latest portfolio review in January 2011.
So... let me ask you this question. If you can earn more than 16% a year in bonds – despite enduring the worst bear market in bonds since the Great Depression – why would you ever bother investing in stocks? How many people do you know who can consistently earn more than 16% a year across their entire portfolio? How many people can do so with such little risk? Even if you're still going to buy a few stocks every now and then, shouldn't most of your assets be in corporate bonds? And if you're going to buy corporate bonds, don't you see why you'd want to focus on the so-called "junk" bonds?
Those are the questions that led me to recruit Mike Williams – who has been a fixed-income analyst since the year I was born. He's by far our most experienced editor. He's simply world-class at what he does. I'm proud of his work and wish more people would give his letter a chance. I know the things Mike can teach you will change your investing life. He's changed mine.