by Steve McDonald, Bond Strategist, The Oxford Club
Friday, June 14, 2013: Issue #2056
As the stock market hangs around all-time highs, a lot of folks are questioning the strength of the bond market.
But don’t be fooled by the folks who paint the picture with a broad brush. There are many easy ways to make money with bonds.
First, you need to understand how they work.
With bond prices through the ceiling and yields through the floor, it is a good time to look at how to earn some hefty returns from bonds even in this “frothy” market.
Let’s go over the basics…
When you buy a bond, you are paid a fixed interest rate (called the coupon rate) from the time you take possession of the bond until you sell or the bond is tendered, called or reaches maturity.
The coupon rate is the simplest idea to understand.
If a bond pays a 7% coupon, the owner gets $70 a year in interest. If it’s a 5% coupon he gets $50 a year. I’m sure you get the routine. It’s easy.
The cash comes in two equal payments every six months until maturity. A coupon is cast in stone and does not change…ever. No matter what happens to the market price of the bond, the coupon rate does not budge.
If you buy a bond for less than par (the $1,000 standard face value of a bond), you still get the coupon interest rate. But the overall rate of return on the bond rises.
A 7% coupon pays $70 a year, but if we purchased it a discount, say $900 per bond, it would have a current yield 7.77%. We get that figure simply by dividing the face value of $900 by the 7% coupon rate. It’s called the current rate.
And, of course, you get paid the bond’s par value ($1,000) at maturity. Not bad!
Sometimes the company that issues a bond has the option to buy back the debt on a preset date. These dates are usually set several years before the bond’s maturity. When a company takes advantage of the option, we say the bond is “called.”
If a bond is called, a company must pay a preset amount, usually a premium, to get the bond back from investors.
For bond owners, it is almost always a good thing.
Similarly, a company may also make a tender offer to buy back a bond at any time. These are almost always a very good deal for the bondholder.
This year, in the Oxford Bond Advantage portfolio, we’ve had 13 bonds either sold, tendered or called. The annual returns we have received for these bonds have been through the roof… anywhere from 12% to 25%.
Two recent tender offers for bonds in our portfolio have been no different.
Last September, I recommended two bonds from a popular drilling company. Both bonds were trading at discounts. One of the bonds came with a coupon of 8.25%. The other sported a hefty 9.125% rate.
Since we paid $964 for the 8.25% bond, and $910 for the 9.125% bond, we locked in current rates of 8.55% and 10.02%, respectively.
Very nice… but it gets better.
While doing my research, I noticed both bonds recently had tender offers, and one was a complete freebie.
First, let me share the details of the conventional tender offer.
The driller offered the owners of the 8.25% bond $1,027.90 if they would sell the bonds back to the company. The offer also included interest payments until the deal closed in early June.
When we do the math, this is where tenders look very good. Remember, we paid about $964 per bond last September.
We will have received eight months of interest – or about $55. And, we also get the difference between our cost of $964 and the tender price of $1027.90.
That’s a gain of $63.90.
When we bought the bond last September we expected to earn a minimum annual return of 9.63%.
By accepting the tender offer our real return jumped to 12.3%… from an ultra-safe bond in what is supposed to be a “return free” market.
Buying Your Vote
But here’s a twist that was new even to me. The 9.125% bond I mentioned above had a very unusual tender offer.
The company offered the owners of that bond $40 per bond to vote yes to allow the company to restructure its debt. In other words, bond owners get to keep their bond and continue to collect the 10.02% yield each year… and they pocket $40 per bond.
All of these numbers sound great, but, if you’ve been around the block a few times, you should be asking what kind of risk these bonds pose. After all, this is supposed to be a zero-interest-rate market. And we don’t get anything for free.
Right now the success ratio for high-yield bonds, rated below BBB, which is what these bonds were rated, is around 98%.
A 98% success ratio means that, in the current market, 98% of all high-yield bonds pay exactly as promised. They pay their interest on time and return $1,000 per bond at maturity.
That means, on average, there are only two defaults for every 100 high-yield corporate bonds on the market. Overall, corporate balance sheets have never been healthier
That’s as safe as you can get while still earning enough to make investing in bonds worthwhile.
On the surface, bonds look simple and bland. But dig deeper to understand the mechanics of the debt market, and it’s clear bonds have something to offer just about every kind of investor.
Take a look below the surface of high-yield bonds. There’s a lot more under the hood than you think. Find the right bond… and you may even get paid to vote.
Editor’s Note: There’s a great reason you don’t know much about the bond market – there’s no incentive for brokers to tell you about it. Brokers are typically incentivized to get their clients to churn through stock transactions and generate fees – certainly not to build wealth for their clients.
And Steve, a former stock broker himself, is sharing a way for anyone to set up as much as $1,187 in monthly income. But you won’t hear about this from your broker. For more details, click here.A 12.3% Yield... and a $40 Bonus,