Article by Investment U
In the 30 years I’ve been banging around the markets, I’ve seen a lot of blood in the streets because of panic.
Most of that “blood” turned out to be solid moneymaking opportunities for more savvy investors.
“Blood in the streets” is the simple result of out-of-favor companies being panic sold – or when the whole market is in a dump mode. But as I’ve written in the past, it’s also an opportunity if you’re trained to spot it.
Learning to look for the right kind of out-of-favor buys takes a long time. It isn’t an easy transition. But, if you survive until you get to the point where you can see the opportunity in sell-offs, you can really start making money.
Think of it as buying a winter coat in the summer time. Most people wait until autumn or winter and pay full price for a coat. But the savvy shoppers will look to find a comparable coat for half the price in July.
The Same Goes for Stocks and Bonds…
This is as true for bonds as it is for stocks. But bonds in out-of-favor companies offer a lot of opportunity and a lot more predictability – along with faster rebound times, too.
In the current market, companies in the business of energy, printing, tech and paper are some of the most unwanted of the street. But some of them can offer big – perhaps very big – paydays.
Not every cheap bond is a good one, though. There are plenty of cheap bonds you should stay away from. These, like some beaten-down stocks, can be costly value traps if you pick the wrong ones. And the wrong one is usually the highflier that catches the eye of rate pigs.
Below is one out-of-favor bond that looks bad and then one that looks much more attractive… You’ll see that just relying on the ratings isn’t enough.
Out of Favor Bond #1 (The Bad): Ultra Petrol (Cusip: 90400XAC8)
This company supplies barge and ship support to oil and gas developers and drillers. As with many energy-related companies, this one has really been smacked by lower gas and oil prices.
It’s a B- rated bond, which isn’t bad. And it sports a 9% coupon that matures in 11/24/14 that we can buy for 88. There’s a call on 8/12 at 101.5 that, if it’s called, will pay us 211%. Ding, ding, ding, big payday!
This normally would look like the perfect bond for us; a very short maturity, a very high annual return of about 15% and a very, very high yield to call, all at a discount. All the right parts!
But, as a friend of mine in the real estate business says, “Check the bones.”
This company has missed its earnings by as much as 300% four of the last four quarters.
It’s expected to earn $0.12 to $0.17 per share next year, up from -$0.65 this year – that’s a positive – but it only has a 4% annual growth estimate for the next five years.
But here are the real warning signs for Ultra Petrol:
- It’s a micro-micro-cap company with a market cap of just $38 million.
- It has a negative profit margin of -8%.
- It’s saddled with $545 million in debt, only $310 million in annual revenue and only $24 million in cash.
How did they get a B- rating? No idea, this is most likely a wreck looking for a place to happen.
Too many investors go out hunting for big yields like this one only to get bad news from the company long after the time to make changes.
Does this mean they’ll definitely default? Not necessarily! But, why take the risk when there are other great bonds that have a much better chance of giving you a nice smooth ride. For instance…
Out of Favor Bond #2 (The Good): Today’s Investment U Plus Pick
I recently recommended what I see as a much better option to my Oxford Bond Advantage subscribers. The company is a worldwide transaction processing company and its bonds are rated CCC+.
But despite the poor rating in comparison to Ultra Petrol, this company is much bigger (it had a $20-billion-plus market cap before it was taken private), is backed by a large private equity firm and it’s much safer. I’ve actually recommended it many times in the past and we’ve always made lots of money on them.
The particular bond I’m recommending has a coupon rate of 11.25%, a price range of 95 to 97, a current yield of 11.84% and it matures on 3/13/16.
Using my MEAR (minimum annual expected return) calculation, we find:
This bond offers eight interest payments of $56.25, plus capital gains of $50 per bond at maturity, minus AI of $30.93, divided by our cost $950 per bond, divided again by our holding period of 44 months, times 12 months for one year, equals a MEAR of 13.46%.
8 x 56.25 + 50 – 30.95 / 950 / 44 x 12 = 13.46%
Here’s where it gets really good…
This bond has two call features. That means the company has the option to buy it back before maturity. We don’t know yet if they will.
If it’s called on the first call date, August 2 of this year, we will earn an annualized return of 105%.
Don’t go out and buy a new car or house just yet. They will pay us 105.625, or $1,056.25 per bond. That’s a $106.25 gain in a month and a few days.
If they offer that much, take the money and run. In real cash numbers, that’s an 11.18% gain in a little over one month.
Next is a call at par in September of 2013. This will give us a yield to the call of 15.58%.
Again, nothing to sneeze at!
13.46%, 15.58%, or 105%? Not bad!
Besides gaining a better understanding of underlying factors affecting a bond choice, this should serve as a wake-up call about ratings. They can err in both directions and should be used only as a very broad indicator, not the only factor in considering a bond.
Remember when they were asleep at the wheel during the sub-prime crisis?
In fact, there are several CC bonds I would like to recommend to my Oxford Bond Advantage, but their ratings are too low to meet the service’s requirement. Too bad!
Be Very Selective When Bottom Fishing
While it’s nice to go out hunting for the big payers, it’s also comforting to not get too aggressive in your choices. Look at more than the annual yield and the rating.
Don’t be a rate pig. They always get slaughtered. A rate pig goes for the highest yield and ignores the other factors. We all have a rate pig in in us, some of us are just better at controlling it than others.
Do the footwork! Look at all the key indicators and fight the urge to play catch-up ball. We have all been beaten up and starved by this income market. Rushing things or forcing choices will only make it worse.
“Keep it real” and back it up with solid numbers and you’ll have a much nicer financial future ahead of you.
Good Investing
Steve
Article by Investment U
