Editor's note: We launched our first bond investment advisory, True Income, in February 2008. Editor Mike Williams has more than 25 years experience in the investment world. And he holds the highly regarded Chartered Financial Analyst designation. Mike's goal is to produce annual returns of 15% for True Income subscribers... Though he's bested that goal every year so far.
Although most of our readers won't ever buy bonds, we continue to offer this service. Why? We think buying discounted, high-yield bonds is one of the safest and best ways to invest. In fact, our founder, Porter Stansberry, says it's his single favorite way to invest. That's why editor Sean Goldsmith recently interviewed Mike about his service. We hope you enjoy it...
Saturday, September 10, 2011
Sean Goldsmith: First off, Mike, thank you for agreeing to this interview. Could you start out by explaining to our newer readers the difference between owning shares of a company's stock and owning its bonds?
Mike Williams: When a corporation needs money to pay bills, expand, or upgrade equipment, it can fund these activities with the cash coming in the door, issuing stock, or borrowing the money by issuing debt. Issuing debt is also called "issuing bonds."
As an owner of a company's common stock, you share in the company's future profits. You're an owner. If a company you own stock in grows its profits by a factor of 10 over a few years, chances are good your stock will be worth a lot more than your original purchase price.
As a bondholder, you have no claim on the company's profits. You're not an owner. You are simply loaning money at a set rate for a predetermined period of time. You are entitled to get your money back plus interest payments, according to a federal statute that governs bond agreements. In other words, your gains are bound by U.S. federal law.
SG: And making money in bonds is far different than making money in stocks, right?
MW: Absolutely. Most people find it incredibly difficult to consistently select stocks that grow their profits (and stockholder's equity) over a long period of time. For every huge success like Google, Home Depot, or McDonald's, thousands upon thousands of dreams wind up bankrupt. And when a company goes bankrupt, the stockholders can lose every cent they have in the company.
Most people don't realize it, but owning stocks is risky. This is why I love being a bondholder. If a company gets into trouble, its bondholders are near the head of the line when it comes to paying bills and creditors. And in the event of an all-out bankruptcy, the assets of the company are sold, and the proceeds are paid to the secured creditors and bondholders. This legal right to be paid is the core of bond investing.
As a bondholder, you don't have to guess who has the best widget or which style of clothing people will like from year to year. You're just loaning money. You simply have to tear through a company's books and determine if it can pay you back over the life of the loan.
To make money over the long term, a stockowner needs many things to go right. And it's unlikely he'll choose the few winners from the many, many losers. As bond investors, we simply have to make sure a company has enough cash coming in the door to pay us back over the life of the loan.
SG: Do you think high-yield bonds are good buys at current prices?
MW: Many high-yield bonds represent excellent values. The True Income portfolio has 13 (out of a total of 24) eligible for purchase. This is more than ever before.
SG: What kind of yields and total returns can I expect buying high-yield bonds today?
MW: True Income's annual return targets are 15%, consisting of 10% in income and 5% in capital gains. We have exceeded our targets each year. Right now, it is easy for a True Income subscriber to build a portfolio (of at least five bonds) that produces a cash yield of 8%-10%. All the investments on True Income's buy list are trading at discounts, so we have the reasonable expectation of future capital gains.
SG: So when you buy a bond, you're legally obligated to be paid back, correct? What happens if a company goes bankrupt?
MW: Bankruptcy means a company cannot pay its bills as it promised. All payments, including interest due to bondholders, are suspended. The bankruptcy court oversees either a reorganization or liquidation of the company. Reorganization means the company continues to operate as before. The liabilities and ownership of the company are reorganized, which means shareholders are wiped out. The reorganized company belongs to the creditors. Creditors can receive new stock, new debt, or both.
The creditors form a queue. The secured creditors are first in line, so they are paid in full, if the company has enough assets. Bonds are unsecured loans, so bondholders stand next in line after secured creditors. Depending on the amount of assets remaining after the secured creditors are paid, bondholders will receive a portion of, or their entire, claim.
A liquidation means all the assets of the company are sold and the proceeds are distributed to the creditors in their order in the queue.
I have recommended three bonds that subsequently declared bankruptcy (out of 41 total recommendations). Our loss was 100% on Aleris. Our loss on Tribune was 42%. And A&P is still in the bankruptcy process. I believe our chance of a full recovery is pretty good. As you can see, the range of outcomes is huge. Owning the bond of a bankrupt company does not necessarily mean a loss.
An occasional bankrupt bond is part of the True Income landscape, and despite my best efforts, I do not believe we can avoid them completely. That is why it is so important to own at least five of these types of investments. A portfolio approach to investing in high-income bonds is essential. And remember... despite these three bankruptcies, we're still exceeding our targeted returns of 15% a year.
SG: Porter loves buying high-yield bonds. In fact, he wrote a Weekend Edition where he talked about bonds, titled "Porter Stansberry's top income investing ideas." One of the reasons he likes these investments is because the cheaper they get, the safer and more lucrative they are to own. Could you explain that?
MW: Imagine a borrower issues bonds at $1,000 each. The borrower must repay $1,000 at the end of the loan or maturity. From the date of issue until the date of maturity, the bond's market value can vary tremendously from $1,000. If a borrower encounters financial difficulties, its bonds are downgraded by the rating agencies, like Standard & Poor's. Let's say the borrower held a triple-B rating – which is investment grade – when the bond was issued. Later, it is downgraded to a double-B, below investment grade.
Many investors in this bond, by law or policy, now must sell the bond at any price. This selling pressure drives the price of the bond down. The sellers take a loss.
The bond now trades at a discount and becomes interesting to True Income.
There are many other reasons a bond might go down in price. All of them benefit us as we now can buy this bond at a much lower price than it was issued. Remember... the borrower must still repay at maturity the full $1,000, regardless of what we paid to own the bond.
All True Income investments are recommended at significant discounts to their par value, or $1,000. The amount of interest the borrower pays is fixed. So as the bond price declines, our yield increases. High yields attract investor interest, putting a floor under the price of high-income bonds.
SG: Could you walk me through a bond you recently recommended in True Income?
MW: Let's look at two. The first is the Rite Aid 6.875% bond due 8/15/2013. We bought the Rite Aid bond in March 2008 for $640. Rite Aid was in the process of integrating a difficult and expensive acquisition. It was reporting losses. But the key point of this investment was the significant amount of cash earnings the company was generating despite reported losses. The cash was more than adequate to pay us.
We still own this bond. We earned interest of $68.75 each year. The current price of this bond is now $970. If we sold this investment today, our total return would be greater than 89%.
Also, in my most recent issue of True Income, from August 2011, I recommended a bond trading for $770 and giving us a lush cash yield of 8.9%. Like Rite Aid, the company has experienced serious operating difficulties. But the company is recovering and is now profitable. It fully satisfies True Income's requirement that it generate enough cash earnings to pay us. I expect the price of this bond to increase as the fortunes of the company improve over our holding period giving us a capital gain.
SG: Thanks for your time, Mike.
MW: My pleasure.
Date Range:9/1/2011 to 9/8/2011
Date Range:9/1/2011 to 9/8/2011