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The Weekend Edition is pulled from the daily Stansberry Digest. The Digest comes free with a subscription to any of our premium products.

How to Take Advantage of the Coming Crisis

By Porter Stansberry
Saturday, November 14, 2015

 In today's essay, more on... bonds. Yes, bonds.
As I mentioned last weekend, I don't blame you for clicking away from this essay. You can live a full and happy life without ever thinking about bonds. However, if you are wealthy, I doubt you will remain so unless you understand bonds at least as well as your wealth manager does.
If you are not yet as wealthy as you would like to be, then I urge you to read carefully. As I have written many times, if there were only one thing I could give to all of my subscribers, it would be an understanding of the advantages of investing in corporate bonds. If my subscribers really understood the corporate bond market, they would never buy stocks again. Alas, there is no such thing as teaching. There is only learning. Those who choose to learn should continue. For everyone else, poverty is a choice, too.
 Let's start here... The bond market is the heart of western civilization. Now, I know, that's a big claim. Most you will never believe it. But here's why I do.
First, the modern bond market traces its origins back to Martin Luther and the Protestant Reformation of 1550. Luther thought there was nothing wrong with charging "fair" rates of interest. God whispered in his ear that 5% should be the standard. Calvin, meanwhile, apparently heard 6%.
Gold merchants, mostly Jewish, apparently didn't care what God thought and charged what the market would bear. They created the basis of the modern financial markets over the next hundred years – beginning mostly with discounting receivables (bills). This is how the concept of the time value of money was developed.
 Before this, charging interest on a loan was illegal in most Western countries. It was considered immoral and defined by the church as "usury." Without access to capital and without capital markets, the West had suffered a tremendous decline for more than 1,000 years. Your teachers called it the Middle Ages. They probably never considered that the Renaissance, with its amazing scientific, artistic, and political progress – and then the Industrial Revolution that followed later – was funded and made possible by Europe's bond markets.
 The conventions, rules, and traditions of the modern bond market were established by the greatest single bond issue of all time. In 1752, the entire English national debt was refunded with a single bond issue that "consolidated" all of the previous bond issues. These bonds, which were perpetual (they never matured), paid 3% at par and were known, for hundreds of years, as "Consols."
They paid interest, in gold, until the end of World War II, when the British government tricked its bondholders into accepting sterling (paper money). The poor fools were then summarily wiped out over the next 30 years as Britain bankrupted itself by adopting socialism. It's truly amazing how 200 years of credit, wealth, and power can be so quickly squandered. But bad ideas have huge consequences.
Still... the 200 years or so that the British Crown paid, honestly and on time, set an important standard. Consols led to the development of more capital markets through Eastern Europe and, most important, America.
Founding father Alexander Hamilton copied the idea and funded our government with perpetual bonds that paid 6%. Later, the Populist president Andrew Jackson wisely paid off all of these debts. What a novel idea! Let's not discuss the track record of our last two presidents in this regard. They have issued bonds that we will never, ever be able to repay. You're welcome, kids and grandkids. Good luck.
 The binary nature of bonds – they're either paid back in full or they default – was established by the British merchant class (known as "Whigs"). They were in favor of using the power of the central government (taxes) to fund their investments. As a result, they structured the Consol bonds to make sure they were always paid interest no matter what.
As private bonds were issued, the same traditions held: Bond payments carried the force of law. There was no way for a bond issuer to pay back part of the note. They either paid in full or they were in "default." For a long time, default meant not only losing your assets, but also going to prison if your assets didn't make your bondholders "whole." He who borrows what isn't hizzn, must pay it back or go to prison.
This binary nature is extremely important. It means that bonds are nothing like stocks. Managers must meet the terms of the bonds they've issued. They must pay interest. And they must pay principal. Sometimes, they must even pay more than principal. Some bonds have a "convertible" feature that allows you to opt to be paid back in stock if the stock is worth more than the money owed.
The binary nature of bonds – perform or default – is the main reason I believe most investors are far better off in bonds than in stocks. (There are plenty of other reasons, which I'll detail later on.) Ask anyone who has worked closely with or has closely observed the inner workings of a public company's management team and I'm sure he will agree.
 There's an almost endless variety of ways that corporate managers can screw over shareholders. For example, instead of paying dividends, they can buy back stock. This will certainly increase the value of their options, but it may or may not deliver value to shareholders. They can use corporate assets to buy other companies, which may or may not be accretive to their own shareholders, but will almost always lead to big bonuses and payouts for management.
Even the most ethical managers will, in some way, be swayed by the mismatch of incentives between managers and shareholders (owners). Managers have a huge incentive to acquire larger and larger piles of assets. Doing so inevitably leads to more job security (more capital to manage), larger staffs, more power, and more prestige. Thus, management teams will always seek to build larger and larger "fiefdoms," even when doing so hurts shareholders by lowering growth rates, reducing returns on equity, and leveraging the balance sheet.
 You'll never see a public company's management team giving itself an honest and objective review. Even America's best managers will never admit that "asset compiling" isn't usually the best way to manage their business and that, more often than not, returning capital to shareholders would lead to higher total returns. Not even investing legend Warren Buffett is honest about this critical test of management efficiency:
Buffett wrote publicly for many years that the test of his skill as a manager was to outperform the S&P 500 on an after-tax basis for any rolling five-year period. For the first time in his entire career, he didn't achieve this goal. So what did he write in his 2014 letter? Going forward, he promised to beat the S&P 500 every six years!
He didn't say anything about his disastrous investment into ConocoPhillips at the top of the oil market in 2008 or his $10 billion investment – the largest of his entire career – into lackluster tech giant IBM. Instead, he made excuses about the size of his portfolio and "moved the goalposts" – something he had spent his career criticizing other CEOs for doing. Keep in mind, Buffett could spin off any of the assets he doesn't want to manage anymore and quickly regain a growth rate that's more appropriate. But will he ever do so? Not a chance.

 Owning bonds allows you to make sure that you get paid no matter what. It allows you to sit back and watch management squirm. They have no choice whether to pay you (thanks British Whigs!). If they don't pay you, woe unto them... A committee of bondholders will foreclose and take all of the company's remaining assets. This can greatly reduce your risk of capital loss – even when you buy risky bonds.
There are tremendous advantages for investors in bonds because of this binary setup. But... because bonds are so different from stocks, you MUST approach bonds in a different way from how you approach stocks.
Think about it like this: Because there are so many different ways that management teams can screw up a publicly traded company, they can usually find a way to fool investors for a while, too. Or they can postpone a day of reckoning for a long time with creative accounting and borrowing more and more money.
But with bonds, companies have to have the cash... or else. It's black and white. It's not a coat of many colors. Bonds don't allow management teams much "wiggle room." That's a good thing in most ways, but it's a bad thing when the bill comes due and there isn't enough cash. There's almost nothing management can do to avoid default.
And that means – and this is very, very, very important – if you're going to invest in corporate bonds, especially in risky corporate bonds that are trading at a big discount from par, you MUST diversify your bets. You must not only diversify in at least 10 – yes, 10 – different bonds, you also need to diversify across risk parameters. Understand this: If all you do is buy one or two of the riskiest bonds we recommend, you will most likely lose a ton of money.
Let me show you exactly what I'm talking about...
 The last time we launched a distressed-debt publication was in 2008. We did so because, as I'm sure you will recall, there was a fantastic "pile up" in the fixed-income markets. Our timing was great. Distress in the corporate-bond market intensified through 2008 and reached an all-time high in early 2009. There were plenty of bonds to consider because, at one point, the average interest rate on non-investment-grade corporate debt was 22% higher than U.S. Treasury securities!
That meant that on average, you were being paid around 30% a year to hold the bonds of thousands of U.S. corporations. I'm sure you realize that not all of these companies were going to go bankrupt. Thus, for any investor who was willing to be diligent and diversified, there was a huge pile of almost free money available – no matter what happened in the stock market.
 There's no way I could have known when we launched True Income in 2008 that the opportunities in bonds would become this good. We knew there would be opportunities... but I never thought we would see those kinds of interest rates.
With the opportunity came plenty of risk: Roughly 12% of all non-investment-grade bonds outstanding defaulted in 2008. And out of the 40 bonds our analyst Mike Williams recommended from 2008 to 2010, three defaulted by January 2011 (a 7.5% default rate). Nevertheless, the average annual return of this portfolio was more than 16% a year in this period – far better than the performance of stocks, which, as you know, fell by half during 2008.
 So, will we have defaults in the future with our new product, Stansberry's Credit Opportunities? Almost certainly. Remember, the outcomes in bonds are binary: They either pay or they default.
Over the next three or four years, I expect to see a tremendous amount of distress in the corporate credit markets. The credit cycle has turned. Credit is tightening. That means the default rate for bonds is going to go higher and higher until it reaches a new peak. During this cycle, I expect that 30%-40% of all non-investment-grade bonds will default. We will not be able to dodge all of these hand grenades.
Likewise, I expect we will see at least 25% of the outstanding investment-grade corporate bonds get downgraded to non-investment-grade status. However, through careful analysis and diversification, I'm 100% certain that the high rates of interest and the capital gains we will accrue across our portfolio will dwarf the losses we may suffer on the defaults. It won't be hard to do because the interest rates on the bonds we will buy will be incredible – all more than 10% a year, many more than 20% a year.
 You will only benefit from these high interest rates if you are disciplined and diversified. Disciplined means you don't "yield shop." You don't simply look at all of the bonds that are trading and then blindly buy the highest-yielding bond. The highest-yielding bond will also be the one with the most risk of default.
Likewise, diversification in bonds is the only way to turn the binary nature of these instruments into a huge advantage for you. If you only buy one or two, you're just gambling. But if you buy 10 or 12, you can dramatically reduce the volatility of your bond portfolio while also increasing your average returns.
 As you might imagine, I was proud of the work Mike did in True Income. And I know that for many of our subscribers, this was their favorite Stansberry Research publication of all time. I had hundreds of letters from people telling me that they had never made more great investments in their life.
But guess what? True Income was also the most hated research service I have ever published. I received more over-the-top vitriolic comments about this newsletter than any other product that I published for any length of time. Many people today still write to me years later to tell me that the one thing I did that they can never forgive was to publish True Income. I know it was the best letter we ever published, from the standpoint of win percentage, total average return, and risk-to-return. And yet many, many people hated it.
What explains this shocking dichotomy? It's simple. Anyone who took our actual advice and bought at least 10 bonds did well. They loved buying bonds because it worked for them and they respected Mike's careful analysis. Most of the people who only bought one or two bonds, however, got crushed. They yield shopped. You can guess what happened to them.
Mark my words: The exact same thing will happen during the next credit cycle with Stansberry's Credit Opportunities. The people who understand the binary nature of bonds will manage their portfolio accordingly, by diversifying. And those who don't... well, they will blame it on us.
 Finally... here's a simple question: If you knew you could make 16% a year in bonds over the next three or four years (which is probably more than you've made during your life in stocks), despite investing during a period of dramatically rising default rates, why would you ever buy stocks again?
My bet is you wouldn't. The only reason you don't invest only in bonds is that you don't really understand them or you don't believe that this kind of performance is likely or even possible. That's fine. I'm happy to prove it.
I just put the finishing touches on a brand-new video presentation that discusses the incredible once-in-a-generation opportunity in distressed corporate bonds. You can watch it – and learn more about Stansberry's Credit Opportunitiesright here.
Porter Stansberry

This Week's Winners
S&P 500 Symbol Change
Plum Creek Timber PCL +14.4%
Qorvo QRVO +13.1%
Monster Beverage MNST +12.3%

Countries Symbol Change
Japan EWJ -0.2%
Ireland IRL -0.9%
Hong Kong EWH -1.5%

Sectors Symbol Change
Media PBS -0.4%
Homebuilding ITB -0.6%
Internet FDN -1.1%

Commodities Change
Orange Juice +16.0%
Lumber +2.3%
Sugar +1.4%
Date Range:11/5/2015 to 11/12/2015
From The Crux
This Week's Losers
S&P 500 Symbol Change
Freeport-McMoRan FCX -23.6%
Mallinckrodt MNK -19.7%
Macy's M -19.1%

Countries Symbol Change
Russia RSX -7.3%
South Africa EZA -7.1%
Taiwan EWT -6.7%

Sectors Symbol Change
Clean Energy PBW -9.0%
Big Oil IXC -5.7%
Water PHO -5.7%

Commodities Change
Brent Crude -8.2%
Platinum -8.0%
Palladium -7.9%
Date Range:11/5/2015 to 11/12/2015
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