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 chan