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Saturday, November 7, 2015
In today's essay, I'm only going to write about bonds.
I can already hear the "clicks" as many of you close out of this essay and go on with your lives. I don't blame you at all. You can lead a full and happy life without any knowledge of the bond market and without ever buying a single bond.
But let me suggest that very, very few people can remain wealthy unless they know at least something about bonds. I'm confident that anyone with a reasonable amount of intelligence and discipline can become wealthy investing only in bonds. So if you don't like the risk or the volatility of the stock market, I hope you'll pay close attention.
I want to start with the three primary reasons why it's vastly easier to make a lot of money in bonds than it is in stocks. You'll find those reasons below.
Why am I so passionate about bonds, especially for individual investors? First and foremost, it is because bonds are much safer and easier to value than stocks. When companies (or governments) sell bonds, they make a promise to pay interest and to repay 100% of the principal. This right carries the force of law. A bond constitutes a legal promise to repay.
That's why, with even just a modicum of knowledge and a bit of common sense, it's difficult to lose money in bonds. (It's not impossible of course, but it's difficult.) Having dealt in equity research for nearly 20 years, I can tell you the exact opposite is true about stocks. It is very difficult for "normal" people to learn to become successful investors in the stock market.
If you doubt this, just ask the most popular accountant in your hometown how many of his clients make money in the stock market. He'll tell you it's less than 10%. He'll also tell you that his clients almost always make money with bonds.
The same legal structure that makes bonds safe also makes them easy to understand and to value. A bond has only two primary components. There's the price, which starts out as "par." Generally in the U.S., bonds are issued in $1,000 increments. A bond trading at "par" is quoted as being "100." That really means it will cost you $1,000 to buy it.
The second component is its coupon. The coupon is quoted as a fraction or a percentage. A $1,000 bond with a 6.5% coupon would pay its owner $65 per year in interest. These coupons are generally paid twice a year – or sometimes more frequently, depending on how the bond is written. If the payments were made twice a year, you wouldn't get $65 twice. You'd be paid $32.50 in June and $32.50 in December.
The key to understanding bond prices and how they might change is to always remember that the coupon is fixed. As interest rates change, the prices of bonds will fluctuate. If interest rates go down, everything else being equal, the price of your bond will go up. That's because the coupon is fixed.
For the rate of interest to change, the bond price must change. Likewise, if interest rates go up, the prices of bonds will go down – at least, temporarily. But if you hold your bonds to maturity (when the principal is repaid), then these changes in price can be meaningless. You're still going to be paid back $1,000 per bond. Assuming you're happy with the nominal coupon, there's nothing to worry about.
That's a lot safer than owning stocks. As you know, stock prices bounce around for no apparent reason all the time. Stocks can be hard to value, which means it's possible to pay way too much for them when you buy, and it's possible to sell them for far less than they're worth.
Plus, a stock's dividends are far from guaranteed. Bondholders don't have to worry about their coupon payments being lowered. The coupon is legally required to be paid. Companies have to meet that obligation, or else the bondholders are entitled to certain underlying collateral. Unless they can pay, these companies will default and enter into bankruptcy. This generally wipes out equity holders, so they will avoid default at all costs.
Think of the movie Goodfellas.
There's a scene where the lead mobster, Henry Hill, is explaining what happens when people borrow money from the mob. The answer is, no matter what happens, they have to make their interest payments. Or as Henry puts it in the movie, "The guy's gotta come up with Paulie's money every week, no matter what. Business bad? F**k you, pay me. Oh, you had a fire? F**k you, pay me. Place got hit by lightning, huh? F**k you, pay me." When you're holding a bond, you're Paulie. No matter what happens, they have to pay you... or else.
Now... there's one big "but." If the company truly can't pay its debts and is heading for bankruptcy, these legal guarantees are worth much less. But they are worth something (at least, typically). Over the long term, credit-ratings agency Moody's finds that corporate bonds have an average recovery of about $0.40 on the dollar. I believe that recoveries will be dramatically smaller during the next crisis. I expect that recoveries will probably average between $0.25 and $0.30.
The key thing to remember is that unlike stocks, bonds don't normally go to zero. That means if you're buying a bond at a significant discount to par, you can usually reduce your actual investment risk substantially. You can't do this with stocks.
Now... I want to make sure you understand something. Even though all of the above is true, you don't want a bond you own to end up in bankruptcy. As you surely know if you've ever been involved in a lawsuit, the one thing you're sure to not find in a U.S. courtroom is justice.
My argument isn't that there's no risk in bonds – there certainly is risk. My argument is that there is much less risk in bonds than there is in stocks. In my experience, I find that most individual investors' biggest problem – on a fairly regular basis – is that they put far too much capital in one stock... which inevitably ends up being the stock that goes to zero.
Rather than cutting their losses, they end up riding it all the way down – taking a "catastrophic" loss that wipes out several years of profitable trading. These kinds of catastrophic losses are almost impossible to experience in a bond portfolio, assuming you've used even a modicum of common sense and diversification.
One important word of caution: It's likely that one or two out of every dozen of our bond recommendations will end up going bankrupt.
We cannot generate substantial returns without taking some risks. But these odds of success are much better than any stock portfolio I could build for you. Likewise, I believe our total return on bonds will be at least as good as the return on the stocks we recommend (and probably higher) over the next three or four years.
If you're the kind of person who decides to only buy the riskiest bond we recommend all year – and if you put 25% of your portfolio into it or something crazy like that – don't blame me. That's not what I'm recommending. So dear reader, if your intention is to destroy yourself, let me save you some time: You can find a way to do it with bonds.
I often think finance was invented because God has a wonderful sense of humor and loves irony more than any other form of mirth. You would think, knowing how much safer bonds are than stocks... and how much easier bonds are to value... that individual investors would strongly favor bonds over stocks.
If you landed on Earth from Mars and the first thing you learned was that investors rarely lose money in bonds and that investors lose money in stocks almost all the time... you would probably guess that there would be dozens of discount brokers offering advice about bonds and service for bondholders.
But there aren't.
Brokerage firms do almost nothing to educate their clients about the bond market. Instead, financial-services companies revolve around selling stocks to their clients and trading stocks for their clients. Why do you think it is that if you call your broker and ask to buy a stock, you can do so in seconds... but if you call your broker and ask to buy a bond, you will immediately be discouraged?
Perhaps it's because the wealth-management business doesn't exist to make its clients rich. It exists because its clients are rich, at least when they first walk in the door.
Think about it. Why have you seen thousands of advertisements urging you to buy stocks, but not a single advertisement – ever – urging you to buy corporate bonds? Hmm...
The second reason why it's easier to make a lot of money with bonds is that most institutional investors are forbidden from owning bonds that don't carry an "investment-grade" credit rating. These institutions – banks, insurance companies, and pensions – can't accept any risk of default.
That means during periods of tightening credit conditions and increasing credit-rating downgrades, there will be huge pools of fairly safe bonds (not completely safe, but fairly safe) that must be sold, and only a few institutions that are allowed to buy them. This forced selling creates huge market inefficiencies.
Think about the price you would get for your house if you had to sell within 30 days, but suddenly no one in your community was able to get a mortgage. In that environment, where there was both a huge lack of available financing (a lack of "liquidity") and forced selling, the result would be a huge decline in the value of your house, a decline that would bear no relationship to the utility or the value of your property.
Or you can think about it like this: What if mutual funds and other institutions were never allowed to own a stock unless it was trading within a certain valuation range? Any stocks that got too cheap (less than 10 times earnings) were viewed as being in decline, and any stocks that got too expensive (more than 20 times earnings) were viewed as being too risky.
If that investment policy were adopted by every institutional investment firm and if there were no exceptions to the policy, don't you think it would be a lot easier as an individual investor to spot companies whose growth prospects made them worth a lot more than 20 times earnings?
Don't you think it would be easier to buy great businesses that are suffering short-term declines in earnings? You wouldn't have any competition to find the outliers in the stock market anymore.
Well, that's exactly what happens with corporate bonds. It's not that most junk-rated bonds aren't worth much. It's just that some of them don't deserve to be rated as junk. And unlike in the stock market, it's not hard to find these exceptions... at least in part because most of the investors in the bond market aren't even looking for them.
Finally... investing in bonds is much easier than investing in stocks because the knowledge that is required is merely basic math. Unlike stocks, bonds are binary. There are only two outcomes. Either both the interest and the principal are paid in full, or they aren't.
(Technically, there's a third possible outcome, which is that your bond is "called back" by the company and you're forced to sell. That's only a problem if you've paid more than par for your bond, which is something I recommend you never do, so that won't happen to Stansberry's Credit Opportunities subscribers.)
With bonds, all you have to figure out is whether the company is producing enough cash to make its interest payments. That's all. If the answer is yes, with a substantial margin of safety, you can generally buy the bond. Another way of making sure it's safe to buy the bond is to figure out what the company's net assets are worth in liquidation, which means at a substantial discount to their stated value on the balance sheet.
As an equity analyst, virtually nothing is more difficult than trying to reconcile the real economics of a business with its accounting. Companies can legally report their earnings to look vastly different by merely changing a few variables and assumptions. Most of the time, the accountants will sign off on these changes, too. These things can turn what looks like a profitable business into something spiraling toward bankruptcy.
But with bonds, you don't even look at earnings. All that matters is the cash accounting. This is a much easier, simpler, and less risky way to analyze a business. Plus, with bonds, you aren't trying to figure out the upside. With bonds, you know exactly what you'll be paid and when.
This eliminates half your work. You don't need to worry about selling. That allows you to strictly focus on the downside. Can this company pay me? How do I know? How sure am I about this conclusion? What could go wrong? What are the odds that it will?
We've built a huge analytical machine for answering these questions. We are able to analyze almost every single corporate bond that trades in the U.S. – more than 30,000 separate issues.
And while we consider the major credit agencies' ratings, we built our own. About 97% of our ratings match Moody's and Standard & Poor's. But sometimes they don't. It's these outliers that we're focusing on – the companies we're certain can pay us, but where other investors have their doubts and where most institutional investors simply aren't allowed to buy. (Within this group of outliers, there are also times where the ratings agencies will think a bond is safe and we won't.)
I can't wait to show you more of our work. If you've been impressed with our Stansberry Data Insurance Value Monitor, I know you'll be blown away with the amount of homework we've done on corporate bonds. I'm 100% certain that there's nothing like our work anywhere else in financial newsletters, and probably not anywhere else outside of elite hedge funds.
Date Range:10/29/2015 to 11/5/2015
Date Range:10/29/2015 to 11/5/2015