What the heck is the “32% Clause?”

By Travis Johnson, Stock Gumshoe, March 14, 2011

Mike Williams, who edits the True Income newsletter from Stansberry & Associates, has been trying to get new subscribers by promising to reveal the secrets of the “32% clause” that can pay you a huge annual income stream.

So what on earth is he talking about? Here’s how the ad begins:

“Introducing: A completely legal and clever way to make American companies like, Sears, Rite Aid or Toys R Us, agree to pay you a 32% annual income stream…

“This has nothing to do with: collecting dividends… using options… or the stock market in any way.

“It’s the easiest way I know to set up a $12,393 or larger annual income!”

Sounds pretty good, right? And according to the self-assigned grades at Stansberry, this letter has lately been their best — so what’s the secret?

Well, probably many of you will guess what the basic investment is that’s being teased — hint, it rhymes with “monk fronds” — here’s an example from early in the letter:

“Take Sears for instance…

“If you’d known about this opportunity in March 2009, you could’ve invested $7,000. But rather than buying the stock through a broker, you could have taken advantage of a unique feature in one of their investment contracts.

“In return, they would have been obligated start sending you $2,270 a year, for the next 7 years.”

He gives several other examples as we run through the ad, too — names like Toys R Us, Hertz, Rite Aid, probably all names that you know, and all names that could have given you something like the income teased as coming from this “32% clause.”

And though what’s being teased is a fairly ordinary part of the investment marketplace, it of course helps them to sell newsletters if they make it seem like it’s unusual or mysterious … though Williams is rather more forthcoming in this ad than he and others have been in ads for similar services in the past. Here’s how he puts it:

“What exactly is a 32% Clause?

“It’s a unique feature you can find on some investment vehicles companies offer that’s outside the stock market.

“You see, when companies want to raise money, they usually offer new issues of a security.

“For instance, they may issue more voting shares or non-voting shares, preferred stock, corporate bonds, debentures, or promissory notes, to name just a few.

“And whenever companies create these new issues, they must fill out certain forms and register them with the SEC.

“Now, what most people – even some brokers – don’t realize… is that there’s a feature on some of these new issues that can contractually obligate a company to pay investors a large amount of income.

“This feature is what I call the 32% Clause.”

And then he runs through the benefits of the “32% Clause” investments … there are four basic ones:

1: Know what you’ll be paid.
2: Legal obligation to pay you, unlike stock dividends, which can be stopped or changed.
3: Opportunity for higher yields than in the stock market.
and 4: Growth opportunity as the company is obligated to return more than your original investment.

So what is Mike Williams talking about? What is the “32% Clause?”

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These investments are, to put it simply, corporate bonds. Mike Williams looks for and recommends high-yield corporate bonds — and in many cases, those that are classified as “junk” bonds by most ratings agencies or that would be considered as such by many investors … bonds that are “below investment grade” and have unusually high income payouts and trade at a discount to principal.

And, to be fair, Williams does put some reasonable caveats in the article — like this one:

“… with these types of investments, it’s often possible to get a better yield than any blue chip dividend… government or municipal bond will ever give you.

“You see, with these types of investments, you can usually find businesses that offer 5% to 10%. This in itself is better than most other investments.

“But here’s the thing…

“Every so often, I come across situations that could pay a whole lot more. I’m talking about 16%… 38%… or even 40% or more. ”

And in this quote, we get to the heart of the matter:

“Now, I want to point out, these situations don’t happen often. For example, the ones I’ve just shown you happened at an extraordinary time. In early 2009, when the markets were bottoming out.

“But these are exactly the kind of situations I look for.

“Compare them to what you’d see anywhere else, and you’ll see what I mean…
…bank CD’s will only pay you between 1% and 2% … the dividend yield on the S&P 500 is around 2%… and 5 to 10 year municipal bonds will only pay between 2% and 3%.

“But thanks to the 32% Clause, you could have the opportunity to get much more than that.

“For instance, if you put together a portfolio of four of my current recommendations… you could see an average yield of 8.9%!”

So … would you have read his ad (or even read this far in my article) if he had talked about the “8.9% Clause?”

Now, I’ll give Mike Williams credit — he has been recommending these high yield corporate bonds since his newsletter launched a few years ago, and there have indeed been some spectacular picks. But yes, early 2009 was, as we have come to find out, an extremely special case — and it was also a year that probably shook loose a fair number of his subscribers, since lots of folks, even if their newsletter adviser is telling them to hold on, would probably sell with both hands if their bonds fell more than 50% in value.

He did recommend (and at a few points, even tease in prior ads) those Rite Aid bonds, but at the time the company was mired in a turnaround effort, was heavily indebted, and people thought they might go bankrupt — the stock even got down to a low of about 20 cents when the market collapsed two years ago. No one wanted to invest in companies that were levered up and unprofitable or marginally profitable, as Rite Aid was — but now, even though Rite Aid still carries about $6 billion in debt (against only one billion in stock market equity), and is unprofitable, and has a stock price down around a dollar, that same bond that you could have bought back at the bottom in 2009 at probably 15 cents on the dollar with nearly a 100% income yield, is now trading at more than 95 cents on the dollar with a yield of less than 10%. The environment has changed dramatically, even for the bonds of not-super-healthy companies.

Williams was teasing a Rite Aid bond way back when he launched this service, too, in the Summer of 2008, just before the debt markets collapsed completely for almost a year. If it was the same bond, which I’m not completely certain of, he probably initially pitched it at something like 50-60 cents on the dollar, so his subscribers would have had to hold on through some frightening months to get to the great performance the bond has now shown — they would have had to hold an investment that they thought was worth $600 as the market wrote it down to just over $100 and, perhaps as difficult, continued to hold on as it climbed back up to $500, $600 and gradually back to approaching “par” in recent months. Not at all easy to do, though I’m sure they’re happy if they did hold on. And of course, if you had the steel stomach to buy corporate debt at the bottom of the market in March 2009 you would be in spectacular shape with Rite Aid bonds, with nearly a 1,000% return.

And no, companies that actually have assets and sales and the hope of eventual profits don’t see their debt trading at 15 cents on the dollar very often. I can’t come up with a second example.

Which isn’t to say that there’s anything wrong with corporate bonds — or with Mike Williams and his recommendations, for that matter, you can see the thoughts that subscribers have shared over at Stock Gumshoe Reviews and what will become immediately clear to you is that the folks who subscribed in 2008 were pissed off in early 2009 when their bonds were trading at half the price they’d paid and a couple of his recommendations were in bankruptcy, but that subscribers were much happier six months later when many of those bonds had recovered. We don’t have many more recent reviews, but according to Porter Stansberry’s published comments and his own “A++” rating for the service, Williams had a good year in 2010.

So I don’t think you’re likely to see many of those “32% clause” recommendations in the months ahead from Mike Williams, but maybe some returns close to that level will emerge if there’s a debt crisis of some sort, or a bankruptcy fear that causes corporate debt to be mispriced. I don’t know if you’ll end up liking Mike Williams’ recommendations if you choose to pony up the $2,400 to subscribe, but do note that folks who are buying up junk bonds at 80 cents on the dollar are, on average, probably getting a far lousier deal than they were two years ago — back then, everything was written down and bonds of good companies that just had a pretty big debt load were trading at steep discounts; now, no one is worried about corporate indebtedness anymore and most of the bonds that trade at steep discounts are probably from far riskier companies.

If you need a quick primer on corporate bonds, here are the basics:

Corporate bonds are generally identified by a CUSIP number, which acts sort of like a ticker for most online research resources and brokers. The number for the Rite Aid bond that matures in August of 2013, for example, is 767754AD6.

Most bonds trade in face value of $1,000 per bond, which we can usually think of as the “principal” — the amount of money the company initially borrowed. Different brokers work in different ways, but it’s often tough to buy corporate bonds that don’t trade very actively, so it may require a phone call to buy a bond. Size matters, too, many bonds are far easier to buy in increments of 10 or 100 bonds than just two or three, so you need a pretty big portfolio to get any kind of diversification if you’re buying individual bonds.

The coupon for a bond is the interest rate that was set when the bond was initially sold — so for that Rite Aid bond that was issued in 1993, the coupon was 6.875%, meaning that those who lent Rite Aid $1,000 in 1993 would earn $68.75 per year in interest. Most bonds pay out twice a year, so cut that in half and that’s your semiannual coupon payment.

The yield takes that coupon payment, which typically never changes (there are some adjustable bonds, but they’re very rare), and divides it by the actual market price of the bond instead of the principal to get what you can actually expect to earn by buying the bond. So when one of these Rite Aid bonds got down to $600 in the Summer of 2008, the yield would have been 11.5%.

And the yield to maturity can be higher still — that’s because bonds at maturity are expected to return the full principal, so if you had bought that Rite Aid bond at $600 in July 2008, you would expect that you would receive not only the $68.75 per year but also get a big capital gain when Rite Aid pays back the principal of $1,000 in August 2013. So that would have given Rite Aid — again, at the time in the Summer of 2008 — an expected annual yield to maturity of roughly 25% (that’s a simplification, I just divided that $400 discount from principal by 5 for the five years remaining until maturity, and added it to the annual coupon) or a total expected return of better than 100%.

The fact that these bonds can trade at a discount to principal is what Mike Williams means when he says that you can get “growth” from these “32% Clause” investments — and yes, to be clear, that same Rite Aid bond trades at a very small discount now, your $1,000 in face value would cost you $975, so there’s not much of a “boost” from that, the bond has already been repriced to the benefit of the bondholders who held through those very hard times, and the effective yield to maturity is more like 8% now.

There are some bonds that are convertible or that have other specific features that impact their price (ie, they can be called by the company or sold back by investors, or they have some inflation protection), but most of them are just a term loan — the company borrows the money for five years (or whatever — the terms can be any length), and their promise is that they will pay you your annual interest due along the way and return the full amount of principal at the end. The value of that bond relative to other bonds depends on the strength of the company, and your conviction that they’ll actually be able to make good on their promise, and the value of all bonds depends on your perception of inflation and the relative merits of other asset classes.

On that simple structure you can write a lot of different stories that depend on the company, the economy, interest rates, you name it. If you think a company will do very well, it will probably see its bonds go up in price at least a little bit as time passes, because new investors who are buying bonds will require a lower interest rate from the perceived-to-be-stronger company, and the only way to lower the interest rate for an existing bond is to raise the price (that’s why you see some $1,000 face value bonds trading at $1,070, for example); if you think interest rates will rise considerably in the coming years, then the bond might go down substantially in price, since new investors could get higher yields from new debt and your bond will have to trade in that higher yield marketplace — and the only way to increase the effective yield on a bond is to have the price fall.

The basic rationale for investing in this kind of debt, if you read between the lines of Mike Williams’ teaser, is that even companies that have a significant risk of default, with a low bond rating from the ratings agencies (assuming anyone believes Moody’s or S&P at all anymore) are still a better bet than common stocks — not only because the guarantee in the bond means that bondholders get first crack at the assets in any bankruptcy proceeding, but because lots of bonds trade at substantial discounts to their principal value without ever actually going bankrupt, so if you choose carefully and diversify you should be able to do well. That’s basically the promise that he must be making to his subscribers — as stock picking newsletters will try to beat the market, Williams and other bond-focused newsletter editors will try to find you above-average yields and below-average rates of bankruptcy or default.

If you do choose to invest in corporate debt, please don’t extrapolate from the March 2009 experience and tell yourself that buying bonds for 50 cents on the dollar is necessarily a good deal now like it certainly was (in retrospect) then — now we sometimes see individual company bonds discounted heavily, but not the entire market, and if you want to bet on the viability of those companies you’ll have to believe that you know more than the credit analysts (or, of course, you can always get lucky).

For example, if you do a search for bonds priced under $700 now (ie, a discount to principal of at least 30%) and maturing within four or five years, you come up with hairy beasts like Crystallex (22942FAA9), which is hoping that international arbitration will get them some recourse from the Venezuelan government, small companies that are presumably facing challenges, like recycled paperboard manufacturer Newark Group or Mrs. Fields Famous Brands (which may well be paying interest in cookies, my broker won’t trade it), or strange structured products that are listed by the names of major banks but not actually guaranteed by those banks — and most of these ugly ducklings rarely trade, even if you did want to get involved. Rite Aid looked lousy three years ago, but I’d argue that it wasn’t nearly as scary as a lot of the stuff that trades at a similarly big discount now.

And if you want to talk about stuff that trades even cheaper, it gets pretty ugly — Raser Technologies, my old favorite “Turkey of the Year” is in there at $350, and so is your favorite food-court pizza joint, Sbarro, which had a loan default a couple months ago and has hired bankruptcy consultants. If you find gems in that pile you can make a lot of money, but I suspect it’s tough work. Many brokerage firms let you trade corporate bonds online in the secondary market (ie, buying from other investors) and will give you some data or let you search for these kinds of bonds, but one of my favorite data sources to use in screening for these is FINRA, which will provide pretty good info on most relatively tradable bonds even if their prices may not be up to the moment.

I should also make clear that I certainly know less about bonds than Mike Williams does — and although I suggested some more mainstream long-term corporate debt to the Irregulars back in April of 2009, I wouldn’t buy any of those bonds today, and I didn’t have the guts to buy junk bonds at that time, either. Whether or not Mike Williams will be able to do well for you in an environment like this one, I have no idea, but I think you’d be wise to read the more cautious statements in his letter and think about 8% returns, not the “headline” 32% returns.

It’s probably also telling that, despite the tease about the riches available for this “32% Clause”, Williams didn’t tease us with the promise of his next hot pick, or details of any currently discount-priced bonds in his portfolio — I suppose it’s possible that he was quaking in his boots that the Gumshoe might sniff ’em out if he provided too many clues, but I think it’s more likely that he doesn’t have many (if any) 30%+ yields to promise from these prices.

So that’s my take on your “32% Clause” — if you’ve got some favorite corporate bonds to tell us about, or other ways you’re happily pocketing income in this low-interest-rate world, I’m sure we’d all be delighted to hear them.

And please, if you have subscribed to True Income, help us keep the reviews up to date by sharing your current thoughts — click here to post your opinion and rating at Stock Gumshoe Reviews. Thanks!



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March 14, 2011 1:45 pm

Great advice in a newsletter can be hidden by ineffectual communications, bad timing, and a few bad picks. As a subscriber to True Income this is what prevented me from profiting from it. I enthusiastically bought into Williams' first pick, a Tribune bond. Williams wrote that "it can pay us" and he hyped Sam "The Gravedancer" Zell as if he were a superhero. When Tribune went bankrupt and the bonds dived hard I lost a lot of money. So did other subscribers whose letters were published. On the other hand, many of Williams' picks did fabulously well, but his lukewarm descriptions were far from persuasive, especially after the Tribune fiasco. Then I bought A&P bonds on his recommendation; this time I sold before the bankruptcy and at break-even. There is a mismatch between Williams writing and my judgment–and I know that my judgme