Doc's note: Today, Mike DiBiase details an unorthodox way to protect your portfolio from the next market crash. If you've been worried about what's coming next, this is how to get ready...
Are you worried about where the stock market is headed next?
Despite this year's rise in stocks, plenty of investors are.
You can still stay invested for the upside while using a number of techniques to protect yourself against the potential downside. Our editors at Stansberry Research have shared many of them here in Health & Wealth Bulletin. These include things like raising cash... adding short positions to your portfolio... buying high-quality, capital-efficient companies... and closely following your trailing stops.
But today, I want to offer you another way to protect your wealth. Used correctly, it's another valuable tool to put in your investing "toolbox"...
I'm talking about buying corporate bonds.
Before you stop reading, bear with me... I know bonds in general aren't considered "sexy." But I'm not talking about buying U.S. Treasury bonds or corporate bonds with yields that rarely even keep up with inflation.
I'm talking about a little-known strategy that only the world's wealthiest investors use. It's a way to earn equity-like returns with far less risk than investing in stocks. Most investors have never heard about this strategy, let alone considered using it.
Here's the best part of the strategy: You don't have to worry at all about a stock market collapse or a bear market, which could last for years.
The state of the stock market has absolutely no effect on the returns you can earn with these investments.
That might be hard to believe, but it's true... With this strategy, you can sleep extremely well at night knowing your capital isn't at risk based on the market's whims.
Here's what I mean...
Simply put, a corporate bond is a loan made to a company. Companies need capital to run and grow their businesses. To raise capital, they can either issue new shares of their stock or borrow money. One way to borrow money is by issuing bonds.
Bonds are usually initially sold in increments of $1,000. That's called their face value, or "par." So a company looking to raise $500 million will issue 500,000 bonds, each with a par value of $1,000 per bond. The company has to pay back the full $1,000 par value on the bond's stated maturity date.
In addition to paying you the $1,000 par value – also known as the bond's "principal" – at maturity, the company also must pay you interest along the way. (Without interest, investors would have no incentive to lend money to companies only to receive their initial capital later.)
Interest is determined by each bond's stated coupon rate. The coupon rate is based on the par value. It's a fixed rate that doesn't change. For example, a bond with an 8% coupon means that you are entitled to receive interest of $80 every year ($1,000 par value x 8% coupon rate = $80). Bondholders are typically paid interest twice per year... In this example, you'd receive $40 interest payments every six months.
Just like stocks, a bond's market price fluctuates. It can trade for far more or far less than its $1,000 par value.
And just like with stocks, individual investors can purchase many bonds in their brokerage accounts. Plus, bonds don't necessarily require a large investment. You can often buy as few as two bonds ($2,000 face value) through your brokerage account.
But here's an important difference to remember: Unlike a stock, once you buy a bond, you are locking in your return. So the price fluctuations are less important. That's the beauty of this strategy.
This is possible because investing in corporate bonds is vastly different than investing in stocks.
With a stock, the company doesn't legally owe you anything... not even a dividend.
But the company is legally obligated to repay a bond. It must pay you the entire $1,000 par value of every bond at maturity, regardless of how much you paid for the bond. It's also legally obligated to pay you all the interest owed along the way, and on time. It must pay or it can be forced into bankruptcy. This legal obligation is what separates bonds from stocks... And it's what makes them much, much safer.
Another important difference is that bonds are higher in the capital structure than stocks. That just means that if a company is going through bankruptcy, bond investors get paid before stock investors from the sale of the company's assets. Historically, bond investors tend to recover around $0.40 on the dollar of their investments, on average. Meanwhile, stock investors almost always get completely wiped out.
If you've been paying attention to today's essay, two things should be crystal clear by now: One, the downside of bonds is much lesser than that of stocks, as bonds rarely go to zero, even in a bankruptcy. And two, the upside of bonds is generally lower than that of stocks.
I say "generally" because in some rare cases, you can enjoy the stock-like upside potential with none of the stock-like downside...
Remember... the bond issuer is legally obligated to pay you the full $1,000 principal, plus interest. But some bonds trade for big discounts to par – $900, $800, $700... or even less.
By buying bonds at distressed prices like this – what we call "penny bonds" – you can generate huge returns... as long as the company pays off the bond in full. That's why many of the world's wealthiest investors – like Howard Marks, David Tepper, and Seth Klarman – buy penny bonds to earn stock-like returns.
On top of that, you earn steady, predictable interest payments along the way. And here's another secret: The effective interest rate on penny bonds is much higher than the bond's stated coupon rate. In other words, if you buy a bond for $800 that pays an 8% coupon, your effective interest rate on the bond isn't 8%... it's 10%. That's the $80 in annual interest payments divided by your $800 purchase price.
The key to this strategy is finding the safe distressed bonds... the bonds where the market got it wrong. That's what my colleague Bill McGilton and I do. We scour through thousands of corporate bonds every month looking for the one or two safe bonds that are trading at distressed prices and offering large yields.
Investing in distressed bonds is one tool every investor should have in his toolbox. It's a way to earn safe, outsized returns... regardless of what the market is doing.
Editor's note: To prove that anyone can use this strategy to make safe gains, we handed the "mic" over to a subscriber. Four years ago, he revealed exactly how this strategy helped him retire at age 52. And today, he's back to help us explain why the latest credit crisis will be a moneymaking field day for investors who follow Mike's strategy. Get all the details right here.