Mega Bonds: Closest thing to a perfect investment?

By Travis Johnson, Stock Gumshoe, February 9, 2009

Many of the delightful readers of Gumshoe Nation have sent in this ad, for the True Income service from Stansberry & Associates. As with so many ads these days, it teases us that, (if we’ll just subscribe and follow their advice), we can make tremendous profits with lower risk.

Here’s how it opens:

Can “Mega-Bond” #559211AC1 really pay a MINIMUM of 77% by Dec. 15th, 2009?

“Unlike any investment I’d heard of before, “Mega-Bonds” offer the security of regular bonds… with all the upside of stocks.”

I’ll give you the quick answer: Yes, it “can.” It may or may not, but it can.

So what is this Mega-Bond? And since we probably care about more than just #559211AC1, of what ilk is our strangely numbered friend?

I’m glad you asked.

Unlike previous teasers for this service, they actually “spill the beans” in the text of the letter about this particular “Mega-Bond” — it happens to be a bond issued by Magna Entertainment, which is big in the news for us in the DC area (and for the Stansberry folks in the Baltimore area) because they own some racetracks and they’re involved in trying to get licenses for the first legal slot machine parlors in Maryland.

They’re also not real popular, according to investors in their common stock — the shares (MECA) are at about 50 cents, steadily and sharply down from $100 in 2006 and about $20 about six months ago.

And that number for this “Mega-Bond,” 559211AC1, is what’s called a CUSIP number — that’s an identifying number that most securities traded on the after market have, sort of like a stock ticker that helps to make sure that all parties know you’re talking about the same thing when you buy and sell.

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In this case, the bond is a convertible corporate bond, meaning it’s a loan to a corporation and, in some circumstances, the bondholders can convert their stake into equity and perhaps benefit from a rising stock price as a result. I wrote a bit about convertible bonds just last week, when Justice Litle at Oxford was calling them “Crisis Bonds,” so I won’t go into great depth on what they are today, but the general idea is fairly simple — you lend a company money, and they pay interest, just like with any bond, but if the common stock really takes off you might get some nice extra capital gains, too.

And in this case, as with most of the previous teasers we’ve seen from the True Income service, it’s very much a “junk” bond — which usually means that it’s rated as being below investment grade, and therefore at some greater risk of default, by the ratings agencies. That’s not technically the case here, but that’s because MECA is not rated by Moody’s, S&P or Fitch, probably because they’re small and broke and didn’t pay to be rated.

Still, I feel comfortable in calling it a “junk” convertible bond — the bond last traded for about $31 on a principal of $100, and it is due next December 15. So that means if the principal is to be repaid next winter as the firm is required to do, you’d get an automatic profit of about 200% just from that repayment. As you can imagine, that means investors don’t think they’re going to get all their principal back.

Now, in this particular case it’s quite a complicated bond, and a complicated situation, which is also part of the reason why the common stock of the company is so beaten down — Magna Entertainment is not just involved in a high stakes bid to build a slot machine parlor at one of its racetracks just outside the Capital Beltway, they’re also in the midst of a major restructuring that essentially looks like it will have them taken over by one of their major investors, according to the press releases I read. I don’t know how far along they are in this restructuring, so be quite careful and take anything I say here with at least a grain of salt.

There is some kind of provision for retiring this convertible debt before it expires, but I have no idea what the terms might be, or if they’ve even approached bondholders yet about possible terms. So if you’re actually interested in this particular convertible bond, I’d be very careful to read carefully — if this big restructuring is completed, it seems very unlikely that there will really be a “conversion” to equity, even if you assume that the equity will ever go up again, though I suppose it’s possible that the retirement of that debt might lead to a profit for debtholders at current prices — again, “possible,” I have no real idea.

The bond pays interest semiannually in the amount of $7.50 a year (the original bond was a 7.5% interest payer, on a $100 principal), so now the yield is about 25% — but according to the timing of their payments there are probably only two interest payments left, one sometime this summer and one at maturity. The bond can be called at any time after February 26 for $100, so that would really be the dream, to have your $30 bond called away for $100, but, thanks to this restructuring, I have even less of an idea than I would otherwise about whether or when this will happen.

The ad letter also tells us that “Mega Bonds” (can we call them convertible bonds now?) were the path to riches for some of the most famous investors we know …

“‘Mega-Bonds’ were kept secret by the world’s wealthiest investors, who used them to make an absolute killing.

“Warren Buffett, for instance, is famous for investing in value stocks.

“But what few people know is that ‘he made himself the world’s richest person thanks in part to [Mega-Bonds],’ says Tom Taulli of the USC’s Marshall School of Business. ‘That’s his preferred method of investing.’

“And Bill Gross, the legendary founder of PIMCO, wrote his Masters’ thesis on ‘Mega-Bonds.'”

If you’re curious about those two, the article that quotes Taulli about Buffett is here (from Entrepreneur magazine in 2004). And Gross did write a thesis about convertibles in graduate school, though I can’t imagine any of us would be excited to read it at the moment.

I don’t have anything against convertible bonds, or against investing in the other high-yield corporate debt that Mike Williams and his publishers have teased before for his True Income service. Still, do keep in mind that corporate debt is the “in” investment right now — everyone is urging you to run to corporate bonds (admittedly, more people are probably pushing investment grade bonds, not high yield “junk” bonds or convertibles). That doesn’t mean it’s wrong to loan corporations money, but it does mean that you’re part of a crowd of folks who are all doing the same thing … which can mean that you end up overpaying.

If you’re interested in looking for any of the “Mega-Bonds” mentioned specifically in the ad, you can always just punch the CUSIP number or the company name and ticker into one of the bond search engines to see the basic details — this is what the description page looks like from FINRA for the Magna Entertainment convertible bond, and you can use their advanced search here to find others, or just enter CUSIP numbers at InvestingInBonds.com’s advanced search page to get some of the trading details.

But there’s more! Williams is apparently recommending some specific bonds to his subscribers right now, with a bit of teaser info about them, so let’s see if we can figure out what those are:

“A little-known network of hospitals has just issued a “Mega-Bond” that is due to pay a minimum 36% return on May 15, 2014. It also pays $489 each year in interest (assuming a $10,000 investment). But best of all, it could pay you 64% or more if the stock goes up…”

I can’t tell you for sure, because the best match I have doesn’t match that $489 coupon payment, but the most likely match for this one seems to be LifePoint — the basic info on this convertible bond is here, the CUSIP number is 53219LAH2 if you’d like to research it further.

It’s priced at about $73 for a $100 principal amount that is due on May 15, 2014, so you would get almost exactly a 36% return just by holding to maturity and getting your money back, even if you ignore the coupon payments. I haven’t checked to see what the convertible part of this offering might be (ie, what ratio or target price), but the bond is yielding about 10% right now and the company does not seem wildly indebted at a quick glance, and it’s currently profitable — this bond is rated B by S&P and Fitch, which means the financial situation “varies noticeably,” it’s two steps down from investment grade but is certainly better than the C rated bonds that are currently “vulnerable.”

“And the new “Mega-Bond” issued by a New Jersey-based supermarket chain is set to pay a minimum 72% on December 15, 2012… PLUS interest payments of $581 every six months… AND the potential to make as much as 110% if the stock price shoots up…”

This one, in all likelihood, is A&P — the Great Atlantic and Pacific Tea Company (GAP), one of the really great company names. People sometimes look to grocery stores as safe investment havens in a recession, since we’ve all got to eat, but A&P has been in trouble for many years — they do have a big ‘ol debt load, though they’ve also gotten bigger in the past year or so by buying Pathmark, so perhaps those improving sales will help them with economies of scale. They may well survive, I have no idea. The Fool recently ran an article about them being on “deathwatch,” which may or may not mean anything, and they have managed to survive for something like 150 years so far, which also doesn’t seem to mean much to the market gods in this particular enviromment. The bonds do trade for just under $60, with a massive yield so the return to maturity would be in the neighborhood of 72% on December 15, 2012, haven’t checked the conversion details for this one, either. It looks like the coupon payments would probably give you a yield of about 11.5%, but the yield to maturity would, of course, be much higher thanks to the fact that it trades at such a huge discount to the principal value.

If you’d like to see the details on the A&P bond, the basics are here — it’s CUSIP #390064AK9, just FYI.

I’m no real expert on bonds, or certainly on corporate debt specifically, but one of the reasons that people have been urging us to buy corporate bonds is because the “spread” has gotten so big that it’s out of whack and must shrink. When folks talk about the spread in this context, they mean the difference between “riskless” US treasury bonds and corporate bonds. Often the spread between treasury bonds and highly rated investment grade debt has been just a couple percentage points, or even less, but now it’s much larger. There are two ways for this to “revert to the mean” — either treasury bonds can go down in price (and get a higher yield), or corporate bonds can go up in price (and get a lower yield). Or both could happen simultaneously, of course.

I don’t know what the future will bring, but I think it’s worth arguing that, given the state of the economy right now, corporate bonds are at least fairly priced, and possibly overpriced — the large spread is not because people are irrationally afraid of corporate debt, it’s because people are irrationally lending their money to the US government at incredibly cheap rates.

If defaults go up significantly, as all the prognosticators seem to expect, then we should demand a much higher interest rate — and if highly leveraged companies go bankrupt during a period of asset deflation, and after years of relying on easy credit, it’s quite possible that many of them won’t have enough real assets to pay back their creditors.

And of course, the main reason that Treasury bonds are so cheap (though they’ve come back a bit already) is that us government bonds remain one of the few “safe” refuges from investment risk in the world — and because people see deflation, not inflation. If inflation comes back at any appreciable level, almost all kinds of bonds will probably be awful investments (with the possible exception of inflation protected bonds, and convertible bonds of companies that might thrive in inflationary times).

That’s not a prediction on my part, I don’t know if bonds will turn out to be good buys — or, for that matter, if Mike Williams and his True Income service will be able to dig into the numbers and pick the best low-grade debt for you to buy, from the companies that are most likely to be able to meet their obligations. I just know two things: Everyone’s suddenly talking about buying corporate debt, in part because the legal protection of that principal gives some comfort, and that popularity scares me a little bit; and if you lend money to a company you should make sure to understand that company’s prospects at least as well as you do when you invest in its common stock.

To their credit, they do include a bit of a warning about the complexity of these investments in the ad, though the warning largely serves to make their service seem more important:

“Unless you have decades of investment experience, I strongly advise you NOT to buy “Mega-Bonds” without the guidance of an expert.

“The first thing you need to understand is that the details you’ll need to successfully research individual “Mega-Bonds” are not easily accessible. You won’t find them listed in the pages of The Wall Street Journal.

“Second, each individual “Mega-Bond” has a unique 9-digit code. Without an industry “insider” like Mike Williams, who knows where to find these codes, it’s difficult for the average investor to take advantage.”

You can certainly find those 9-digit codes, the CUSIP numbers, using any of a number of sources, including the FINRA links I included above — but I’d have to agree with the general principle: These are hard investments for some individuals (including me) to understand, and it can be especially tough to build a diversified portfolio of corporate debt of any kind unless you have a large portfolio and the time to pick up a new time-consuming hobby. That’s why, when you hear pundits talk about the appealing nature of high yield debt, corporate debt, or convertible bonds, they will often suggest letting a mutual fund or closed-end fund manager handle the buying for you. That was the argument of Justice Litle last week, in his teaser for one of the Calamos closed end funds, but there are many funds available of both the closed-end and traditional mutual variety that can provide some diversification and professional management, if that’s what you’re looking for (as always, it’s usually wise to look for experienced, successful managers and lower fees).

The True Income service is fairly new, and I haven’t heard much about the experiences of any subscribers — if you’ve subscribed and think it was either worthwhile or worthless (or somewhere in between), please visit our new Reviews section and let us know your thoughts. Or if you’re buying up some nice high yield corporate debt or convertibles right now, by all means, let us know what you like (or don’t like).


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Nick Cellino
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Nick Cellino
February 9, 2009 1:22 pm

I’m passing along an analyst report card that Porter Stansberry published to describe the performance of his analysts in 2008 in which he admits that most of his publications produced negative average returns in 2008. Rob Fannon, the writer of Phase 1, was actually given an “F” by Porter. Mike Williams, the creator of True Income, was given a grade of “Incomplete”, although the average bond he recommended during 2008 fell 35%, because holders continue to be paid their coupons and may recoup all of their losses at maturity. Tom Dyson and Steve Sjuggerud were give the grade of “C”. It’s somewhat refreshing to see such candor on the part of a publisher.

Nick Cellino

“Part II: Why Trailing Stop Losses Matter
By Porter Stansberry

As I told you Friday, while I believe it’s important to measure performance (and to demand good performance), I don’t believe any given year’s quantitative result is the only (or even the best) measure of quality.

Most of our publications produced negative average returns in 2008. Does that mean we did a bad job? Does that mean we’re bad analysts and you’re wasting your money reading our newsletters? Some folks undoubtedly think so.

Last year was the worst year for stocks since 1931. It was the third-worst annual performance of all time. Each major subgroup of the S&P 500 was down more than 20%. Stocks on average fell about 40%. The average mutual fund was down 40%. All our publications did much better than this. And as I showed you on Friday, we were among the few analysts anywhere to predict much of the carnage and get many of the big themes right: real estate, the investment banks, Fannie and Freddie, GM, Goldman, etc.

Our highlights weren’t only on the short side, either. Only two Dow Jones Industrial Average components went up in 2008: Wal-Mart and McDonald’s. Only one significant takeover went through last year: Budweiser. All three of these stocks have been long-time “strong buys” at Stansberry. I told my subscribers back in 2006 they could put up to 25% of their portfolio in Budweiser – the largest allocation I’ve ever recommended. I also reminded people to buy BUD when it was trading under $60 in October while the all-cash $70 InBev buyout was pending. Ferris pounded the table on Wal-Mart in late 2007. It was his top pick for 2008 at our Alliance conference. Likewise, McDonald’s was one of Tom Dyson’s first recommendations for The 12% Letter.

I understand you expect our recommendations to go up – whether the market goes up or not. And an analyst isn’t going to get a good grade from me (an “A” or “B”) unless he has a positive track record. But here’s a question to ask yourself: Am I a better investor after reading S&A research? Looking at our work in 2008, I think there’s no question we’ve given you excellent advice. We urged caution and told you where the trouble was coming from. We put you short the stocks that blew up and long the best stocks of 2008. And on average, our portfolios performed much better than the market.

One factor was critical to our group’s outperformance: sell discipline. Most of our editors follow rigorous trailing stop losses, usually at 25%. I learned this technique from Steve Sjuggerud, who was among the first newsletter writers (if not the very first) to use the strategy in his letters, starting nearly 15 years ago. We get a large number of complaints from readers anytime we sell a stock – whether for a loss or a gain. Lots of people “fall in love” with their stocks and never want to sell.

If you fall into that trap, consider these numbers: The average loss on Steve’s picks in True Wealth last year was 5.7%. Out of his 15 recommendations, four went up, nine went down, and two broke even. While still producing an average loss, Steve’s average return was a loss anyone could live with compared to the market’s average result (down 40%).

But without trailing stop losses, the damage would have been far worse. If Steve had held instead of following his stops, his average loss on the seven stocks he stopped out of would have been 29%, which would have dragged down his overall results considerably.

I have to give Steve a “C” for the year because he didn’t produce a positive return. But I think he did a good job for readers by cutting his losses, recommending “virtual banks” (which produced good returns), not making any recommendation in July when the market wasn’t safe, and picking lots of good companies after the market bottomed in November.

Tom Dyson’s sell discipline also spared his 12% Letter readers massive losses. Says Tom:

Stop losses probably saved my career. They protected me from some substantial losses, especially on some picks I made in late 2007… The high-yield sector of the stock market was the epicenter of the great credit crunch of 2008. Many of the stocks in my universe were leveraged and employed financial engineering to goose payouts. Many of the stocks in my universe were in the real estate or lending businesses… or in bed with them. If there’s one thing I did right this year, it was avoiding finance and real estate all year. But to no avail. Every stock I picked this year lost money…

Even so, Tom’s average loss was only 9.9%. That’s good enough to earn him a “C” for the year. Staying away from leveraged real estate and business development companies was smart, but there was nowhere to hide last year. Everything fell.

Tom says he learned one valuable lesson last year: “I am now very wary of structured products like REITs, MLPs, income trusts, closed-end funds, BDCs, etc. that use fancy structures to attract income investors. They almost always come with huge debts, complicated financial statements, and wizard accountants. You never quite know what is inside the black box…”

As you would expect, we experienced a negative average return in our S&A Oil Report. With the price of oil falling from near $150 to under $50, you might think we saw double-digit losses in oil stocks – but not from our oil analyst. Matt Badiali stopped out of nearly every recommendation this year and limited his average loss to 6%. No one ever wants to lose money, but minimizing losses during bear markets is absolutely critical to long-term results, and Matt did a great job of that this year.

First, he captured gains on picks made early in the year (Allis-Chalmers, Oilsands Quest) and then he hedged his portfolio with puts on the highly leveraged Peabody Energy – which soared. So even though he only gets a “C,” I think he did a great job for our readers. (For comparison, look at T. Boone Pickens, who was running an energy-centric fund. He ended the year down 60%.)

Again highlighting the importance of risk management, our worst results of 2008 came from portfolios where we weren’t using trailing stop losses, or where those trailing stops were set wide.

Our most disappointing result was in our new True Income letter. Based on December prices, the average bond recommended during 2008 fell 35%. But there’s a big asterisk attached to these numbers.

Our bond analyst, Mike Williams, is the most experienced on our staff. He has literally been researching fixed-income investments for as long as I’ve been alive (he started in 1972), and he’s the only analyst at Stansberry to have earned his CFA designation. Mike is convinced these bonds will pay off at prices at or above their recommended prices – and most of them at par, which would result in significant capital gains.

It doesn’t make sense to use trailing stop losses on bonds because bonds, unlike stocks, have a legal obligation to return 100% of their principal amounts to their owners. In the meantime, holders continue to be paid their coupons – which are substantial. Thus, we should recoup all of our losses (and more), as long as we’re willing to hold to maturity. We’re also collecting coupon payments while we wait.

Mike generally recommends bonds that mature in one to three years, so we should know pretty quickly whether this strategy works as well as it should or whether the losses on these bonds will hurt our principal.

In the meantime, though, the corporate-bond market has been in total panic since the collapse of Lehman Brothers. So… for now, we’ll give Mike an “incomplete” grade for 2008. If you’re interested in buying bonds (I believe you should be), make sure you check out his list. If Mike’s analysis is correct, you should be able to make 25%-35% annually in his bonds – which is more money than you’re likely to make in stocks. (Read more about Mike’s strategy here.)

The worst result of the year in stocks – an average loss of 22% on 13 recommendations – came from Rob Fannon, who writes Phase 1, our early-stage technology letter. Rob’s results included three picks down more than 50%, which reflects the wide stop losses he sets on his recommendations.

Because early-stage technology companies are incredibly volatile, it’s difficult for Rob to set tighter stops. In good times, Rob can produce average results in excess of 100% a year. But in bad times, the losses will be severe – that’s the nature of high-risk investing. Unfortunately, given these results, I have to award Rob an “F” for his 2008 campaign.

We’ve tried to improve our “hit” ratio in biotech investing by focusing on stocks that have received so-called “complete response” letters from the FDA. Dr. George Huang researches these situations in our S&A FDA Report. Frequently, a biotech company will see its stock fall more than 50% in only a few days after receiving such a letter. That creates a perfect opportunity for us to move in and buy at depressed prices.

George has done a fantastic job of trading in and out of these situations. In what was one of the worst years ever for biotech (along with everything else), George’s 14 trading recommendations averaged a profit of 14%. Even more impressively, 10 of George’s trades were still open as of the end of December. George earned an “A+” in 2008. There aren’t many investors anywhere who produced better results, in any market.

To summarize… what was a horrible year in stocks – nearly the worst ever – was only a bump in the road for most of our portfolios. We only had two products with double-digit losses, and one of these was our bond letter, where we expect to recoup our losses at maturity. We also produced outstanding gains with Jeff Clark’s S&A Short Report and George Huang’s FDA Report.

Given the enormous crash in all of the world’s equity markets, I am very proud of our results. I hope you’ve benefited materially from our work.”

Warm regards,

Porter Stansberry
Baltimore, Maryland
February 2, 2009

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angelo venerus
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angelo venerus
February 9, 2009 1:32 pm

What parameters/ financial data should we be researching when evaluating a mega bond?

Earl McCaskill
Member
Earl McCaskill
February 9, 2009 1:59 pm

Are there not some funds which invest only in convertible debentures? If so, what are the names of a few, and what are their track records?

STEVE B
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STEVE B
February 9, 2009 2:11 pm

Mystery solved – AGAIN! – thanks GumShoe!

EYOUNG
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EYOUNG
February 9, 2009 9:45 pm

And in addition to Angelo and Earl, are there ETF’s in this business of Convertible Debentures???
Need to do my homework, I know~!
EYoung

john
Guest
February 9, 2009 10:55 pm

tried peter once and invested a couple of time never made a nickle then tried his 12% letter again down the tube, came to the conclusion that the only way you can make money in the letter business is to write one and get you a good sucker list. bingo

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john
Guest
February 9, 2009 10:58 pm

have had the most luck in selling puts on some of the major stocks. have averaged about 10% on a yearly basis. don’t see much risk in 3 dollar GE or 2 dollar bank of america.

Garry Cleverdon
Guest
February 10, 2009 11:23 am

The Stansberry Put Report has been at least for me very successful but I was tracking the Mega Bonds and Rite Aid has fallen off its perch completely and the risk of Chapter 11 seems a possibiliy.

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indya
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indya
February 17, 2009 10:05 am