Why You Should Invest In Bonds

[Igor 10]

Secured Investment Contracts are a unique type of bond - but for most people, these bonds are like nothing you've ever invested in before.

 

Like stocks, these bonds allow you to invest in some of the best companies in America. But unlike stocks, you'll always know exactly when and how much you'll be paid.

 

The bonds I'm going to tell you about are as profitable (or more so) than stocks... come with less risk... and have an exact date on which you'll be paid. As you'll learn, it's the company's bondholders, who hold the legal, first claim to a company's income stream. Stockholders come in around eighth in line.

 

It's possible to double our money in these safe and stable bonds… often in a few short years. Most common-stock investors are lucky to make a fraction of that return consistently.

 

What To Do

 

We look for two major things in a good investment: safety and a high return. We use bonds to find them.

 

When a corporation needs money to pay bills, expand, or upgrade equipment, it can fund these activities with the cash coming in the door, by issuing stock (also called "equity"), or by borrowing the money by issuing debt. This is also called "issuing bonds."

 

As an owner of a company's common stock, you share in the company's future profits. If a company you own stock in grows its profits by a factor of 10 over a few years, chances are good your stock will be worth a lot more than your original purchase price.

 

As a bondholder, you have no claim on the company's profits. You are simply loaning money at a set rate for a predetermined period of time. You are entitled to get your money back plus interest payments according to a federal statute that governs bond agreements. In other words, your gains are bound by U.S. federal law.

 

Most people find it incredibly difficult to consistently select stocks that grow their profits (and stockholder's equity) over a long period of time. For every huge success like Starbucks or Home Depot, there are scores of bankrupt dreams. And when a company goes bankrupt, the stockholders can lose every cent they have in the company.

 

This is why I love being a bondholder. In the event the company gets into trouble, the bondholders are at the head of the line when it comes to paying bills and creditors. And in the event of an all–out bankruptcy, the assets of the company are sold, and the proceeds are paid to the secured creditors and bondholders.

 

This legal right to be paid is the bedrock of this investment philosophy.

 

As bondholders, we don't have to guess who has the best widget or which style of clothing people will like from year to year. We just loan money. We simply have to tear through a company's books and determine if it can pay us off in the time period our bonds are "in play."

 

Why It's Possible To Do This

 

Economic theory says we have to take on greater risk to earn greater returns.

 

I disagree.

 

The stock and bond markets make temporary mistakes. Even the smartest investors can get carried away with their fear and greed… which leads to the "mispricing" of risk.

 

If risk were always properly priced, there would be no investment opportunities for me to tell you about. Investors like Warren Buffett wouldn't be able to buy cheap assets and earn huge returns.

 

In fact, the high returns we can earn are possible because of a significant mispricing of risk. And the market is littered with bonds mispriced by the majority of investors, both professional and amateurs.

 

Two factors create this mispricing.

 

First, most big bond-market participants – like insurance companies and pension funds – can't buy the types of bonds we want to buy. These institutional investors are prohibited from investing in the part of the bond market where we operate.

 

This market is commonly known as the high-yield, or "junk," bond market. A high-yield bond is considered riskier than bonds called "investment grade." Don't worry though… as I'll show you in a moment, we'll use this perception of increased risk to make a lot of money.

 

This lack of "big competition" in the high-yield bond market lets us find great deals without much competition.

 

Think of it like this… if you're one of the few mortgage lenders in a town, you could be very picky about the loans you extend to borrowers. You don't have much competition, so you could demand high rates of interest and plenty of collateral to back your loans.

 

Second, the high-yield market is relatively small and carries a stigma of low quality, which is not always deserved. The quality of a loan is determined by analyzing each individual borrower. As I mentioned, Moody's and S&P often make errors in rating bonds, leading to mispricing in the bond market. Wall Street simply bypasses the forest and leaves a lot of strong trees for us to investigate without much competition.

 

The bonds we want to buy could be called "contrarian bonds." Much like a share of stock, a bond can be sold by investors who are afraid of holding the asset. For instance, in 2008, we bought a bond issued by the Goodyear Tire and Rubber Co., America's largest replacement tire maker.

 

At the time, most investors heard "tires" and ran screaming... assuming if the U.S. auto industry was in desperate straits so must the tire business... But they were wrong and this created our opportunity. Since investors were worried about the outlook for tire makers, you could have bought a contract that entitled you to a payment of $1,000 from Goodyear for just $740.

 

That's right. You paid $740 to get $1,000. Here's how this is possible...

 

How to Make the Biggest Gains in Bonds

 

Just like stocks, bonds trade in a public market that is heavily affected by emotions.

 

And just like stocks, emotions can cause bonds to trade for less than their true value. Professionals call this true value the "intrinsic value."

 

When investors become concerned about a business or industry, they're willing to pay less for the debt obligation of that business… just like they're willing to pay less for a dollar's worth of earnings of that business.

 

Let's say company ABC borrowed $5 million three years ago by issuing 5,000 bonds worth $1,000 each. (Most bonds are issued at $1,000 per bond. This original issue price is called the "face value.")

 

The company agreed to pay its creditors 8% interest for five years. That's an interest payment of $80 per bond each year. The amount borrowed, the interest rate, and the life of the bond can vary greatly. But we're keeping it super simple for our example.

 

Now… let's say ABC is struggling due to new competition or an industry downturn. The bonds ABC issued that originally had a value of $1,000 will fall. Investors aren't as rosy about the company's prospects… so they're only willing to pay $800 per bond.

 

Here's where it gets profitable for you and me…

 

We do a thorough analysis of ABC. We know the company will generate enough cash to pay the interest it owes to its creditors. (Remember, the creditors are first in line to get paid. Shareholders could see their cash dividend disappear). We buy ABC's bonds for $800 per bond. That 8% interest on the original value must be paid.

 

Since we bought the bonds for $800, our $80 in annual interest payments gives us a nice yield of 10% per year. Now come the capital gains…

 

ABC has to pay off all of the $5 million it borrowed in two years (remember, the bonds were issued three years ago). It is contractually obligated to pay $1,000 to the holder of each bond.

 

Since we took advantage of the pessimism toward ABC and did a thorough analysis of its ability to pay its debt, we are rewarded with a 20% gain on our original purchase price. We paid $800 for the bond, earned $80 in interest each year for two years ($160 total interest), and we make a capital gain of $200!

 

Here's how the math works out:

 

Bought ABC bond for $800.

Collected $160 in interest payments.

Received $1,000 when ABC paid off the total debt.

 

We make $360 off our investment of $800 (a 45% gain) in two years.

 

How We Know It's Safe

 

The biggest key to making these big, certain, on-time gains is my ability to perform a solid credit analysis of each and every position.

 

Our bonds must be safe. With all our recommendations, we know the bonds are safe because my analysis says the borrower has adequate resources to pay us. I ensure the company has sufficient assets to pay off our bonds even if it should fall into bankruptcy and be liquidated. That's my job.

 

You see, bonds become deeply discounted because of credit downgrades. A credit agency like Moody's or Standard & Poor's has analyzed the borrower and lowered its opinion of the company's credit quality. Downgraded bonds decline in price because the risk of a borrower default is higher.

 

However, I will not buy a bond unless I am satisfied the borrower has enough resources to pay the interest on the bond and redeem it at maturity. And frankly, most of these bonds are now safe because they have already declined in price. The only reason for a significant further price decline is a default. And, as I said, the value of the borrower's assets in liquidation is enough to pay us.

 

I look for complete coverage of the face value of the bond. This means we have an excellent possibility of not only recovering our investment but of receiving the full value of the bond.

 

Safe, high-yield bonds… that's the core of our strategy. Why would you ever buy stocks...