“On June 15th, 2009, Dayton Superior Corp. is required by federal law to pay investors a 97% ‘Scheduled Distribution’ …
“Right now, more than 100 companies are issuing abnormally large, 1-day payouts to their investors …
“And while most companies are cutting their dividends – or doing away with them entirely – these ‘Scheduled Distributions’ are getting bigger and bigger.”
Thus the ad opens for the True Income service that Stansberry and Associates is trying to sell. So what are these huge payouts, why do they exist, if they do, and what the heck are they talking about?
Gather round, and let’s listen closely to what they have to say …
“Take Ohio-based Dayton Superior Corp., a metals manufacturer, for instance. Even though regular shareholders haven’t made a penny in the past two months… Dayton is due to pay a once-off ‘Scheduled Distribution’ of 97% on June 15th, 2009.
“Keep in mind… the company doesn’t pay a regular dividend… and this payout is not a special dividend either. In fact, you don’t even have to own Dayton Superior stock to collect the ‘Scheduled Distribution.’
“But if you were to put $10,000 into Dayton Superior today… you’d be due a $9,700 check just 7 months from now, as required by Federal law. Plus, you’d get back your original $10,000 stake at the same time.
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“As I mentioned, “Scheduled Distributions” are offered to investors by companies that are looking to expand their business. They have NOTHING to do with the stock market.
“And because it’s harder than ever for companies to get the money they need from banks… and because of the declining stock market… the money being offered in “Scheduled Distributions” is simply off the charts.
“What’s nice for you as an investor is that “Scheduled Distributions” take the guesswork out of investing.
“That’s because, as Money Magazine points out, “Scheduled Distributions” are predictable and stock returns aren’t.”
OK, so those of you who been around these parts for a while, and who were with us when the True Income service was launched with some aggressive ad campaigns a while back, will recognize what they’re talking about: Corporate bonds.
Or, if you prefer to use the term they made up last time, you can call them “Secured Investment Contracts.” I still think that sounds more exciting than “Scheduled Distributions,” but that’s just me. You can read my comments about that Secured Investment Contract teaser ad here if you like, it was used to launch the True Income service back in June and it got a lot of attention from my readers.
So what are corporate bonds? Well, they’re just like treasury bonds — only, instead of lending money to the U.S. government when you buy a bond, you’re lending money to a company. As you might imagine, most investors demand a higher interest rate for lending money to a company, since the possibility that the company won’t pay you back — the default risk — is always going to be higher for an individual corporation than for the country that has the ability to tax all of those corporations.
I won’t go into as much detail on this as I did back in June — the concepts haven’t changed, even though the economy has fallen into the toilet. Shouldn’t have left it on the back of the commode like I did with my Mickey Mouse watch in fourth grade, I guess.
But I will share a few comments, and go into one example:
Bonds are rated on a scale by the ratings agencies — the severely embattled Moody’s, S&P, and Fitch. They give complicated alphabetic rankings to bonds based on the ability of the borrower to pay back the money. Highly rated bonds like AAA or Aa are called “investment grade”, low-rated bonds like CCC are often called “junk.”
And even if the ratings agencies screw up, as they have been wont to do, investors are still generally cognizant of problems in individual corporate bond offerings — they can look and see how much debt a company has relative to earnings, or sales, or whatever metrics they use, and if they believe a company is in trouble they won’t want to buy its bonds (lend it money). If that’s the case, the price of the bonds will fall for want of buyers, and the interest rate — which is set in the bond, it’s almost never variable — will necessarily go up. Just like stocks with huge dividends, high payouts for bonds signal that most investors believe there is something seriously wrong with the company, and that those payouts are threatened. “Most investors” can be wrong, of course, and it is possible for you as an individual to be smarter, better informed, or luckier than they are, just beware the odds.
Pretty much every example given in this ad letter is either a junk bond by rating, or is considered one by investors. That means the interest payments relative to the current market price of the bond will be huge, but also that people think there’s a good chance they won’t get their principal back at maturity.
These scheduled distributions are not, of course, getting “bigger and bigger” — they’re fixed. Unlike dividends, they will never grow (with rare exceptions for some variable debt). What is happening is that investors are getting more and more worried that marginal or highly indebted companies will fail to pay off their debt, so they’re demanding a higher interest rate to buy those bonds. That, in turn, means the prices of the bonds are getting smaller and smaller — conceptually, it’s no different than buying a stock that’s going down, as the stock falls the effective dividend percentage rate goes up even if the amount of the dividend doesn’t change.
Of course, companies can easily cut or cancel their dividend payments — with some rare exceptions, they’re under no obligation to pay dividends to common shareholders. They don’t like to cut dividends, of course, even though the dividend may be a farce — as with Citigroup right now, for example. The tradition of American companies, however, is that they try like hell to pay a rising dividend, and that has created an environment where even companies that have no hope of being profitable for years and years are borrowing money to pay dividends to their shareholders.
Who are they borrowing it from? Well, one of the ways they borrow money to keep operating, to expand, or to pay dividends when they’re not making money, is by issuing bonds to investors. They cannot arbitrarily stop paying the interest on their debt (also called the coupon payments for the bonds) — for that I assume that they’ve either got to renegotiate with their bondholders directly or go through a bankruptcy filing (I’m not a lawyer, there may be other technicalities to that).
So that’s why people like bonds over stocks — bonds have a set payout, and a guaranteed repayment of principal when the bond matures. In some cases, as with a lot of the examples given in this ad and in others by the True Income service, the bonds are very lowly rated and the expiration date is quite soon — so it is indeed possible to get massive payouts like that teased for Dayton Superior, payouts that combine a few coupon interest payments with the return of a principal amount that is much higher than the price at which the bond is currently trading.
Let’s look at that Dayton Superior bond that expires next summer, just as an example. If you’d like to see the details on this you can go to the FINRA website here — this is my favorite source for information on corporate bonds, you can also search there for information about other bonds you might be interested in. (FiNRA is the nonprofit national regulatory body for securities dealers.)
The theoretical payout for Dayton Superior bonds right now would be about 110% over about seven months, it appears to me — that certainly sounds awfully good right now, no? Dayton Superior has a bond that matures next Summer, on June 30, 2009. It has a coupon rate of 13% — meaning that when the bond was first issued for $100, it paid interest of $13 a year. And they have to pay back the $100 principal on June 30 of next year.
The bond can be bought and sold through pretty much any broker, just like a stock, though, so it’s not necessarily worth $100 to any investors right now — in fact, according to FINRA these shares last changed hands on November 4 for $60. That would have meant you were due two interest payments (the bond pays semiannually) of $13 each, so $26, plus $100 at maturity — so for your $60 investment (or whatever a more current price for the bond might be) they are “legally obligated” to pay you something like $126 next Summer.
Is that likely? Well, Dayton Superior is in a tough business right now, and they have a busload of debt. This is a company (the equity is publicly traded, DSUP is the ticker) that has a market cap of about $7 million and outstanding debt (like these bonds) of close to $400 million. They sell concrete-related stuff for commercial construction — forms, rebar, chemicals, etc., so it wouldn’t be shocking if you assumed their business might suffer a bit in a weak economy. That’s even worse than GM, which has about $1 billion in market cap and a debt load of around $30 billion.
The bond that pays off next Summer at that ridiculously high rate is part of an issuance of $170 million in debt, so you’re expecting a company with a bit under $500 million in annual sales, a teeny and sometimes negative profit margin, and negative free cash flow (in some quarters they’ve had positive earnings, in others not), to somehow refinance or pay off that debt if you’re to get your $100 back next year. It’s certainly possible, and some companies in dire straits do make good on their debt and keep plugging along, but it might not be advisable to hold one’s breath while you wait for your check.
And as a corporate bond investor, you also have to remember that while there is that guarantee of payback at maturity, there’s no guarantee at all for the value of that bond inbetween now and then — if you want to sell, or are forced to sell, you’re stuck with whatever the market offers. And for small companies in particular, the market can be very illiquid — as I noted, that particular Dayton Superior bond has not, according to FINRA, traded in the last two weeks.
So … should you invest in corporate bonds? That’s your call. I would urge you to consider this to be quite similar to investing in equity, in terms of the kind of research you do on the companies — regardless of what any ads say, it’s not easy and I think it’s foolish to say that they “take the guesswork out of investing.” If you’re lending someone money, it’s always wise to pay attention to how they’re planning to pay you back, and whether or not you think they’ll really be able to make good.
Or, if you want to dabble in junk bonds but don’t feel like researching all these companies and offerings on your own or subscribing to a service like True Wealth that will do this for you (they don’t have much of a track record yet, I have no idea what their performance will be like), then you can always invest in a mutual fund that buys a diversified portfolio of bonds — mutual fund companies will call these “High Yield Corporate” funds in most cases, they probably find that using the word “junk” in the name is not particularly effective for marketing.
With funds, you don’t get the security of the payback of principal at maturity (a security that may be fleeting for some companies), but you do get a diversified portfolio, and diversification is very hard for a small individual investor to build in the bond market.
So … do you want to lend money to the smaller cousins of GM and Ford? Are there hidden gems in the junk bond market — or are you more excited by the unusually high rates paid by investment grade borrowers these days, or just loath to lend your money out at all? Let us know what you think.