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Why Bonds

(Stool Pigeons Wire) by Trader Joe 2/13/09

Speaking historically, folks would buy stocks for two reasons, [1] capital appreciation (consisting of econimic expansion + growth in the specific company sector) and [2] dividend income. In fact, over most periods (as measured in decades) the return from the dividend component assuming reinvestment, is equal to or more than, the return from capital appreciation. This theory holds fine for periods of economic expansion, and periods of expansion laced with the occassional economic hiccup (mild recession).But from an accounting/legal standpoint things are quite different.

Equity holders are last in line of the capital structure from first to last:

[1] DIP (debtor in posession financing, assuming worse case BK restructuring scenario)
[2] Senior secured debt
[3] Unsecured debt
[4] Mandatory preferred shares (have to pay divs)
[5] Cumulative preferred shares (can accumulate divs if cash tight)
[6] Common stock

So in this environment common stock makes less sense to use as an “investment” than as a “betting chip.” So while one can still “buy stocks” and make money, it is not investing in the traditional sense, but more like betting — and the duration of those bets have contracted dramatically, from years during a traditional expansion economic cycle to months, days and minutes in our current environment.

More and more, “investors” are coming to the realization that stocks are indeed extremely risky and can result in an extended if not permanent impairment of capital (thimk BK). Thus, an “investment” should be able to [1] preserve capital via a claim on assets, and [2] generate income.

That’s where corporate debt comes in.

Corporate debt accomplishes the two important conditions above, and it also stands above [1] stocks price depreciation, [2] dividend cuts/elimination, [3] preferred share depreciation & dividend restriction. The interest payment on debt is THE LAST THING TO GO before bankruptcy. Sure, once in BK, there are no interest payments while going through the process, but on the other hand everyone else has been zeroed out FOREVER. After BK, usually 6-12 months, assuming the company was doing a restructuring the debt holders will emerge with new debt (albeit a fraction of what they held before) and most if not all of the equity in the new firm. Recovery on debt is in a range of 30-70% on the origianl investment dollar assuming you bought the bonds at face ($1,000 per bond or 100%). However, in a liquidation recovery can approach zero.

Currently, the corporate debt market is offering insane yields (8-50% annually depending on risk), but with good reason, as the level of deaults is increasing by the day (I own bonds in several recently BK companies: Pilgrims, Aleris, Tribune, Constar, to name a few). Meanwhile the influx of cash being put to work is increasing dramatically, and while I don’t have stats at the ready, there is almost not a day that goes by where the WSJ is discussing all the new money going into the corporate debt market.

So how can one get involved?

You can by bonds in individual companies (like I do) through any major broker (I use Fidelity). You can either just browse their inventory or call their fixed income desk should you have a specific bond you are looking for. However, two of the easiest way to play the high-yield market are the ETF’s HYG and JNK.

Remember that stocks are really just a derivative — that’s right — a derivative whose value is “derived” from company earnings, hence the focus on measures such as P/E multiples and PEG ratios as a way to “measure” relative value.

Can money be made trading stocks? Absolutely!

Can money be made by buying and holding stocks? Absolutely!

Do most folks have the time to trade stocks or properly analyze & monitor individual stocks? No way!

Bottome line on long term holdings: [1] MAKE SURE YOU ARE GETTING PAID TO WAIT, [2] MAKE SURE YOU HAVE A “REAL CLAIM ON ASSETS” rather then a “CLAIM ON EARNINGS”

2 Comments

  1. eah

    A nice summary. Personally, I have never invested in/traded bonds.

    …and the duration of those bets have contracted dramatically…

    Regarding stocks this is certainly true in my case — I’ve become a trader, not an investor. The advent of these leveraged ETFs has certainly exacerbated this (guilty as charged). And while I rarely enter and exit a trade optimally, I’ve learned that any profitable trade is a good trade.

    More and more, “investors” are coming to the realization that stocks are indeed extremely risky…

    People who bought in at the end of the dotcom era would second that. Definitely something to keep in mind at all times.

    …the ETF’s HYG and JNK.

    Thanks for the symbols.

    No way!

    True, in spades. As you make the transition from investor to trader you must quickly figure this out, especially if you have a day job. This market is particularly dangerous.

  2. Crimson Ghost

    Junk bonds had one of their best January’s EVER even as stocks suffered their worst January EVER.

    Need I say more.

    Personally I prefer open end junk funds like SPHIX to HYG and JNK. The latter can sell at a discount or premium to asset value and are more volatile than the open end funds.

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