If you follow the investing world, you likely know all about Marty Fridson…
He’s one of the most respected researchers and authors in the field of high-yield (or “junk”) debt. Today, he is the chief investment officer at investment-advisory firm Lehmann, Livian, Fridson Advisors.
And each year, he hosts the High Yield Bond Conference in New York…
The event is a great way to “take the pulse” of insiders in the bond market, while keeping up with the latest research.
That’s why I made the trip in June…
Overall, the tone at the conference was surprisingly optimistic.
Most of the speakers – including Fridson – don’t think the junk-bond market is as dangerous as the mainstream media suggests.
They don’t believe the next recession and correction in the credit markets will be nearly as bad as the last one.
And they don’t think it’ll happen within the next year.
With all due respect to Fridson and the other presenters, I don’t agree.
We’ve been down this road before. In all the years leading up to the last financial crisis, outside of one presenter anyone at Stansberry Research can remember, neither Fridson nor any of his many presenters saw the 2008 credit collapse coming… let alone its severity.
As I noted yesterday, the dominoes are already starting to fall in corporate America.
Today, I’ll share more about how you can get through a crisis – and even grow your wealth – by making smart investments in distressed bonds.
No one can argue with the facts… Corporate debt is at an all-time high. And the quality of that debt is much worse than it was before the last financial crisis.
That’s why we launched our Stansberry’s Credit Opportunities newsletter. And it’s why every month, I work with my colleague Bill McGilton to scour the universe of U.S. corporate bonds.
We’re searching for what we’ve called “outliers”… bonds priced far too low for their level of risk. When we’re analyzing whether a bond is safe for us to recommend buying, we focus on a single important question… Can it pay us?
We only care whether a company can pay our interest and principal. That’s all that matters when investing in bonds.
To figure out if a company can do that, we analyze two factors…
- Whether the company can afford the annual interest costs on all of its debt, and
- Whether it will have enough cash on hand to pay off our bond at maturity.
These can get a little technical, but stick with me. I promise, it’s well worth it.
The first factor is the most important…
If the company can’t afford to pay the interest on all of its debt (not just our bond), its lenders can force the company into bankruptcy. We’ll never recommend a bond from a company that we believe will go bankrupt before our bond matures.
That’s why we look at the company’s “interest-coverage ratio.”
For us, that’s how many times the company’s cash profits cover its interest costs. (Cash profits are the cash that a company produces from its core operations. The metric can be found in the statement of cash flows under the “net cash provided by operating activities” line.)
We use this measure because, unlike accounting earnings, cash profits can’t be faked. That’s because cash profits don’t include any estimates that management can easily manipulate. You can’t fake cash.
We like to see interest-coverage ratios of at least two times…
That tells us the company can safely afford its interest payments, with enough cushion to absorb unforeseen downturns in its business.
Besides telling us whether the company can afford its interest payments, this ratio also gives us an idea of how difficult it will be for the company to refinance its debt. Banks want to make sure they will get paid their interest, too. The lower the ratio, the more difficult it will be.
Next, by addressing the second factor, we can figure out whether the company will pay us our principal when it’s due. If it looks like the company won’t have enough cash in the bank at maturity to pay our recommended bond, we know it will need to refinance its debt with other loans to pay us. So if that’s the case, we look for companies that should have no trouble finding financing when the time comes.
We don’t care how we get paid, as long as the company is able to pay us.
In addition to these two factors, we also want to know our worst-case scenario… what would happen in case of a bankruptcy. So we perform a liquidation analysis for every bond.
For this, we run a simple thought experiment. We imagine that the company is forced to shut down its business at some point in the future and sell off all of its assets. We estimate what these assets would be worth in a forced sale.
Then, we allocate the sales proceeds to the company’s lenders. Some lenders – like banks – typically get paid first. Bondholders, along with other unsecured creditors like employees and vendors, typically get paid after all senior and secured creditors are paid.
The good news is… unlike stocks, bonds aren’t worthless in a bankruptcy. On average, bondholders have historically recovered about $0.40 on the dollar in bankruptcies. For some of the bonds we’ve recommended, the amounts we estimate we’d recover in a bankruptcy are higher than the prices we paid for the bonds.
As I’ve explained, we’ll never recommend a bond that we believe is in danger of bankruptcy before we get paid. Still, we can’t guarantee that it will never happen.
Every investment comes with some level of risk. That’s why we must always look for returns that are high enough to compensate us for these risks.
And it’s why this strategy works even better during a credit crisis, when bond prices plummet. You see, bond prices and bond yields are inversely related. So as bond prices fall, their returns rise. The profits you make go up… while your potential losses go down. That makes them even safer investments.
The next crisis is approaching. That’s when the best opportunities will appear.
The good news is, it’s possible to earn huge, safe returns even before a crisis…
From time to time, severe inefficiencies in the bond market cause certain bonds to trade at much lower prices than they should. In turn, the yields of these bonds soar much higher than they should, based on their risk. We call these bonds “outliers.”
It’s only possible to identify these outliers by doing your homework… understanding where the bonds sit in the company’s debt structure and whether they’ll be paid in full.
That’s where we come in. We do all the work of identifying these types of bonds for our subscribers in Stansberry’s Credit Opportunities.
Since we launched in November 2015, we’ve recommended 30 bonds and closed 20 positions with an 85% win rate. Keep in mind… these recommendations all have legal protections that no stock can ever offer.
Meanwhile, the average annualized return of our closed positions is 20.9%. That’s almost two and a half times better than the overall junk-bond market’s return. If you had instead invested in the largest high-yield bond exchange-traded fund, the iShares iBoxx High Yield Corporate Bond Fund (HYG), you would have earned just 8.4% in the same span.
We even beat the return of the stock market… The S&P 500 Index’s weighted return during the same period is 17.1%. And we accomplished this while taking on far less risk.
Keep in mind… we’ve booked these impressive gains before any panic has set in. The biggest opportunities are still ahead of us.
But that doesn’t mean you can’t profit today.
Good investing,
Mike DiBiase
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Source: Daily Wealth