How to Spot the Best Cheap Bonds (And Why Ratings Aren’t Enough)
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: 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 really was smacked by lower gas and oil prices.
It was a B- rated bond, which isn’t bad. And it sported a 9% coupon that matured in 11/24/14, which we could have bought for 88. There was a call on 8/12 at 101.5 that, if it were called, would have paid 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 had missed its earnings for several of the last four quarters.
But here were the real warning signs for Ultra Petrol:
- It’s a micro-micro-cap company with a market cap of just $41.37 million.
- At the time, it had a negative profit margin.
- It was saddled with $545 million in debt, only $310 million in annual revenue and only $24 million in cash.
How did it get a B- rating? No idea, this was 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.
Did this mean it’d 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…
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.
*The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of professional analysts.
About Steve McDonald
Somewhat of a renaissance man, Steve worked as a professional broker and has been an active trader of bonds for more than two decades, specializing in ultra-short-maturity corporate bonds. But before entering the investment industry, Steve was a naval aviator, flying fixed-and rotary-winged aircrafts, and also served as a surface warfare officer. Steve’s regular video series featured on Wealthy Retirement called “Slap in the Face” Award is some the most amusing investment content we republish.