“Bulletproof your Portfolio”

by Travis Johnson, Stock Gumshoe | September 26, 2008 7:34 am

This one comes in from the folks at Investors Daily Edge[1], in an ad for a new service of theirs called The Bond Trader[2], run by a guy named Steve McDonald[3].

So you will not be shocked to hear that this teaser is about investing in debt, not in equity — lending your money to corporations, instead of becoming a part-owner of those same companies.

And it’s no shock that this service is being launched now, nor that it’s being advertised heavily. Investors are in a fully lathered panic about stocks right now, so the idea of something that is a “guaranteed” investment really catches our interest.

There are a few appealing things about bonds — they have set payouts, they are in the front of the line in bankruptcy and “rescue” proceedings, and they are not typically nearly as volatile … and they’re not talked about on CNBC or quoted in your newspaper, and many of them don’t even trade every day, so if you own bonds that are declining in value you won’t be reminded of that every time you look up from your sandwich.

Now, before I go forward let me get this off my chest … there is a little tingle in the back of my mind that proposes the following: If financial newsletters are piling on trying to create bond recommendation services, it probably means that this is the right time to be investing in stocks. After all, as Hulbert has noted a few times, 80% of investment newsletters underperform the market — most of them are marketers first, and unbiased advisers second.

But that said, a lot of my readers are interested in this service, and in the more cryptically touted “Secured Investment Contracts” from Stansberry[4] — so what are they, and what should we look for if this is of interest?

First of all, I should be clear: This “Bond Trader” service from Investors Daily Edge specifically positions itself as an Investment Grade bond newsletter — that’s quite distinct from the True Income[5] service at Stansberry, which doesn’t even mention that their Secured Investment Contracts are bonds, so feels no need to specify that they’re mostly looking at junk bonds.

What do those terms mean? Well, this all relies on those rating agencies that are right now buried deep in the mud and trying hard to restore their reputations — Moody’s, S&P, and Fitch are the big ones. They review bonds and assign ratings to them based on the ability of the issuer to make this a “performing” bond (that is, to pay you your regular interest payments and return your principal at the end of the loan term).

There are different classification systems from the various rating agencies, and they don’t always move in sync, but in general “investment grade” means it is very unlikely to default (historically, what I’ve read is that far less than half of 1% of corporate investment grade bonds default). For Moody’s, investment grade means anything over Baa, for the others who use a different letter system, it’s generally anything over BBB. The A-rated stuff is high investment grade, the Baa or BBB is the bottom end of the investment grade universe — anything lower is perceived to be riskier, with some folks calling anything that’s not investment grade “junk” and some folks reserving the “junk” term for the lowest rated C bonds. B and BB bonds are “somewhat speculative” and have higher risk, those with any C rating like CCC are in significant danger of default, and those with a single C or D rating are either on the verge of defaulting, or have already stopped making interest payments.




So that’s the universe we’re talking about — if you hear talk of “high yield[6]” bonds, they almost always mean corporate junk bonds, a BB rating if you’re looking for a boost in yield and risk, a CCC or CC rating if you’re taking what most people would consider to be wild chances.

This all assumes that the ratings agencies have a leg to stand on, of course — and their opinions should at least be considered, even given their lack of credibility in recent years, if only because these ratings are the language that other investors speak. They have gotten a lot wrong, particularly with those Collateralized Debt Obligations (CDOs) and similar products that got investment grade ratings but didn’t deserve them, and there are many complaints that the model is broken — the ratings agencies are paid by the borrowers to rate their bonds, so there is at least the potential for significant conflict of interest. It’s hard to bite the hand that feeds you.

So basically that’s what bond newsletters do — they tell you which bonds to buy, and how much to offer for them. In the case of the Stansberry offering they’re going to be discount priced junk bonds with high potential yield to maturity (ie, 20, 30, 50% and up), in the Bond Trader case it’s going to be investment grade, which means yields should be much safer and much lower.

So … what about the Bond Trader newsletter specifically? They don’t give many specific clues about the kinds of bonds they’re going to recommend, and it’s a brand new service so they have no track record to use for selling themselves. But they do outline what they’re looking for and tease a couple bonds that they’re recommending now.

Here’s their spiel on two of their recommendations:

“Every bond is issued at a “face value” of $1,000. But as time goes by, various factors in the market can cause a bond to trade for less than its par value. This is called a “discount” and it represents a discount to the amount you will be paid at maturity.

“Steve will almost always recommend bonds that are trading at a discount. That way, you can capture capital gains, plus interest. Add the two together and you get your “total return.”

“Here’s how it works…

“This Company is Legally Obligated to Pay You 40%…

“One of the bonds Steve currently recommends is from a company you would instantly recognize. You can buy this bond today for $795 and it matures in January of 2010.

“This bond pays interest of 7.75% – due in January and June of 2009 and then again in January of 2010. That means you would receive three payments for a total of $116.25 in interest.

“When the bond reaches maturity in January of 2010, the company would be obligated to pay you the face value of $1,000, which represents a capital gain of $205.

“So, let’s do the math…

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“You paid $795 and you received a total of $321.25 in interest and capital gains. That is a 40.4% total return in just over a year… or an annual return of 32.3%.

“Of course, not every recommendation will be quite this profitable.

“In fact, Steve is recommending another investment grade bond right now that is selling for the discounted price of $900. By holding the bond to maturity in 18 months, you would make $67.50 in interest payments… plus a $100 capital gain when the bond is paid in full.

“That represents a 24% gain in just a year and a half… in a very safe investment.

“And it is not just safe. Your return is also completely predictable… no hoping for results.

“In fact, the only way you could lose is if the company went bankrupt and, even then, as a bondholder you’d get paid before the stockholders saw a single penny. While this risk is already very small with an investment grade bond, your risk is further reduced by holding a variety of bonds in your portfolio.

“Sure beats losing money in the stock market!”

So … I actually did do a quick check in my favorite bond screener, and I didn’t see any exact matches for those clues, but there are a few candidates that are similar. And as you might imagine, if you want a very high yield like that for an investment grade bond, it’s going to be for one of the embattled financial companies. It is somewhat controversial that some of these bonds are still highly rated, including debt of AIG, with their government takeover, or Morgan Stanley, which seems to be the odd man out after Merrill Lynch[7] got bought to Bank of America and Goldman Sachs convinced Warren Buffett[8] to endorse them, but yes, you can get a big yield of 20%+ over the next 15 months from a few investment grade issuers.

The one that stands out as the closest match to this teaser is a bond from Morgan Stanley — and let me be clear, I have no idea if this is the Bond Trader’s recommendation, or if it’s worth your time — but here are the details by way of illustration:

This bond matures on January 15, 2010 — which means they will have to pay back the $1,000 face value on that date. It trades using the bond ticker MS.RU or, more commonly, under the CUSIP number of 61746SBC2. The last trade was at $801. The coupon yield is 4%, and that is based on the initial offer price of $1,000, so the actual semiannual interest payments to you would be $20 per bond, payable twice a year. At $800 that gives you a yield of 5%, but the big thing here is not the yield but the yield to maturity — that’s because, if Morgan Stanly stays solvent and makes good on their obligations, they will be paying you back $1,000 on January 15, 2010 for a bond you bought today for $801 (it actually trades in a wide range — you could have bought it for anywhere between $772 and $864 today).

So with this bond, held to maturity in about 15 months, you would get capital gains of roughly 25% plus that 7.5% or so in coupon payments in the interim. This bond is rated in the midrange of investment grade, A1, A+, or AA-, depending on the rating agency you prefer. The full details from the FINRA bond site are here[9], if you’re curious.

Bonds[10] like these are outliers, however — there are only a few investment grade bonds that trade at a big discount to their value at maturity and mature in January of 2010, and they are from Morgan Stanley, AIG, Sallie Mae, and National City. A bit of a rogues gallery of “investment grade” there. Most investment grade bonds yield more like 5-6% and trade fairly close to their value at maturity, at $950+. On the other side, with the junk bonds that folks like True Income’s Mike Williams[11] are apparently recommending, you’ll often find them trading at $600-700 with extremely high yields to maturity … if the company makes it that far and holds up their end of the bargain.

If you’re interested in researching individual corporate bonds[12] and finding out the full details and the CUSIP Number (that’s the best identifier for individual bonds — if you want to buy one, that’s the number you would give your broker), you can try several research tools, probably including some available online from your broker, but I like using FINRA. FINRA is the regulatory body for the stock exchanges, and they have a good database of bonds, including corporate, municipal, and treasury and agency bonds[13]. Click here to go straight to FINRA’s advanced bond screener[14] and play around a little if you like, they’ll also let you search by ratings, by yield, by industry or issuer, or whatever else strikes your fancy.

Be careful — every broker works differently, so I don’t want to generalize, but if you try to get in and out of bonds in any kind of a hurry you’ll probably pay for the privilege. Many brokers charge low per-bond commissions on bond trades but also act as market makers and take a bite of your purchase as a built-in fee that they don’t always explain all that carefully to you. Volume is very low for most of them, too, so the price could be quite different depending on when you’re looking to buy or sell.

Most investment pundits would probably recommend that if you’re a relatively small investor, you let a professional do your corporate bond investing for you — most of these are priced in $1,000 increments, and it’s sometimes difficult to review the details or trade them effectively, so it can be quite hard to build a diversified bond portfolio as a small individual investor. you can get decent yields from many high yield mutual funds[15], from relatively conservative ones like the High Yield Corporate fund from Vanguard to more aggressive Closed End Funds like Blackrock Corporate High Yield (COY) — this is not to suggest that either of those funds is worthwhile, just that there are a broad range of mutual and closed end funds available that focus on this area. The big ETF guys also have offerings in this area, the ones I’ve seen are tickers JNK, HYG and PHB, most of them yield 8-9%. The one big problem with mutual funds or ETFs (other than the fact that some of them charge high fees), is that you’re buying an actively traded basket of bonds, so you don’t get that security of knowing you get your principal back on a set date.

And finally, if this general idea interests you, there are also a series of little-known exchange traded bonds and structured debt products that you can buy which have offering prices of $25 and represent small slices of corporate bonds like these. They’re usually called Exchange Traded Debt or Trust Preferred Securities. They trade much like stocks, though in low volume, but are just pieces of bonds that have been chopped up for individual investors. They are generally for longer terms than the kinds of bonds noted above, and there are many of them that have good yields and trade at a significant discount to their $25 offer price.

The best place I know of to get listings of these is QuantumOnline.com, which is a great free service (you do have to register) that provides lists of all kinds of income securities. As one example that comes to mind just because I looked at it recently, you could buy senior debt of Markel, the insurance company (I own shares) that’s traded on the NYSE under the symbol MKV. The debt matures in 2048, and pays a coupon yield of 7.5% but is current trading at a discount, so the effective yield is more like 10%. This debt is rated at the bottom of investment grade.

So, there are a lot of options[16] if you’d like to look for ways to lend money to companies and get a return that is more fixed and less volatile — on average — than the return on stocks. Unlike dividend payments, companies can’t arbitrarily change the interest they pay on their debt … but this is also a very large negative during inflationary times. Bonds are fixed at a certain price and coupon payment — so while a company that pays a dividend and grows is very likely to increase that dividend as they become more successful or profitable, there will never come a time when they offer to increase their coupon payments on their existing debt. Your interest payments (for almost all bonds) will never go up, no matter what inflation is like for the next year, three years, or 40 years, and while you do get your principal back at the end if the company survives, do keep in mind that if we’re’ talking about a long time period that principal will probably be worth much less at the time that it’s repaid.

The other negative to consider is interest rates in general — if, as many people fear, our current economic malaise is going to lead to raising interest rates across the board over the next several years, then owning bonds will, all else being equal, stink.

Of course, you can always sell the bond to someone else if you decide you don’t like it, but, just as with stocks, there’s no guarantee that someone is going to be willing to pay you a price that you like. If the US Government is paying 5 or 6% on treasury bonds in a few years, then people will demand significantly higher interest rates for riskier corporate bonds. If you own a bond with a 5% coupon, someone would want an effective yield that’s better than the treasury yield to buy it from you, so they might offer you only 80 cents on the dollar. Inflation[17] and rising interest rates make bond ownership very unprofitable, falling interest rates are the bond investors best friend because they allow for capital gains as well if you sell your bond (the market price of the bond doesn’t matter, of course, if you just hold to maturity, but inflation still matters in that the value of your principal drops every year).

I’ve said this before, but in general my preference is to own companies rather than lend them money — but certainly bonds of all types have a place in most portfolios, and if you’re lending money to the US government you won’t even make enough in interest to keep up with inflation, so for real income returns in bonds you do need to take at least some risk with higher yield municipal or corporate bonds. Be careful, though, the bond markets are where the big guys play, and the credit markets in general become more complex every day.

And just like the stock market, the price of something reflects what most people, particularly institutional investors, think is the potential risk — sometimes things are mispriced because of emotional reactions, just as people occasionally overreact to a bad quarter or scary news items by overly punishing a stock, but much of the time bonds that are priced at a big discount are there because a good number of big investors believe that the company is a default risk. They might be wrong, but they are often right.

If you like buying bonds and have a preferred strategy, please let us all know — I’ve shared what I can, but I don’t generally invest in bonds so my comments should be taken with a grain of salt.

full disclosure: of the companies mentioned above, I own shares of Berkshire Hathaway and Markel.

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