The Volcker Rule and Underpriced Corporate Bonds

Steve McDonald
by Steve McDonald, Bond Strategist, The Oxford Club

The Volcker Rule and Underpriced Corporate Bonds

by Steve McDonaldInvestment U Contributing Editor

Thursday, January 19, 2012

[Editor’s Note: For those interested in researching the particular bonds listed in this article, the cusip numbers are as follows: Alion – 016275AF6 and Geokinetics – 37252CAB6.

Almost all of the big money I have made on bonds in the past three years, greater than 25% a year and upwards to 100%, has been from negative outlook and CCC range bonds.

When I recommended bank bonds in 2008 and 2009 people told me I was crazy. When I recommended home builders' bonds in 2010 and 2011, people told me I was crazy. Maybe I am crazy, but I have only ever had three losses in almost 175 bond picks, 2%, 4% and 15%, and am making or made money on all 172 of them.

As I said in the article, these are not the best quality bonds I have ever mentioned in an article. If a CCC rating scares you, you should not be in them. There will be B- and better bonds you may consider coming in other articles.

Keep in mind that investors should do their due diligence on any investment and/or consult their financial advisor before making a decision based on Investment U Research.]

An ideal buying opportunity in corporate bonds is shaping up, and it could be huge.

According to a recent study by the Securities Industry and Financial Markets Association (SIMA), the implementation of the Volcker Rule’s proprietary trading proposals on banks could result in a sell-off in bonds and losses of $90 billion to investors.

The good news – the sell-off has nothing to do with the credit worthiness of the bond issuers.

Essentially what the Volcker Rule would do is make it much more difficult for banks to own and trade bonds of all types in their accounts. The result would be that banks would no longer be market makers in bonds, and the number of market makers could be as low as one for smaller issues.

One market maker means no competition, and we all know what that means for the market.

SIMA worded it this way in their report:

“An overly restrictive implementation of the Volcker Rule [as proposed] would artificially limit banking entities’ ability to facilitate trading, hold inventory at levels sufficient to meet investor demand and actively participate in the market to price assets efficiently – reducing liquidity across a wide spectrum of asset classes.”

Until lately all the talk about reinstating the Volcker Rule only concerned how much the big banks - Goldman, J.P. Morgan and Morgan Stanley - would lose. SIMA put the cost at $43 billion in increased costs and $4 billion in increased transaction costs.

But the really big number is how much bonds could drop in value if the rule is implemented and the number of market makers in bonds is reduced.

Some smaller issue bonds have already sold off well below prices that accurately reflect their underlying fundamentals for no other reason than the possibility of a reduced number of market makers.

All of this sounds very discouraging unless you look at it from a buying perspective. It’s a buyer’s paradise!

Remember, the perfect situation for any investment is to buy it when it’s significantly underpriced, especially if it’s inaccurately priced. That’s exactly what we have in a few small-issues, and could have throughout the market.

Whether corporate bonds are underpriced because of an overreaction to bad news or, as in this case, in anticipation of bad news, buying them cheap means a big payday.

Here are two small-issue bonds that have sold off since last summer because of the threat of the Volcker Rule limits. The returns are bordering on crazy!

Two Bonds Already Selling Off

The Alion bond has a coupon of 10.25% and matures in February 2015. It meets my usual requirement of an ultra-short maturity, just three years.

A 10.25% coupon would be a good buy at par, or $1,000 per bond, but this is selling now for about 50, or $500 per bond. That’s down from 91 last spring.

Here’s where current yield really kicks in…

Current yield is the interest you actually earn based on how much you pay for a bond. If you pay par, you get the coupon, or 10.25%. But at a cost of 50, you get 10.25% divided by your cost of 50, or 20.5%.

And that’s just in interest! You also get par, or $1,000 per bond, at maturity for another 100% capital gain.

Keep in mind, about the only reason this bond is down is because of the threat, not the implementation, of the Volcker Rule limitations. The underlying fundamentals are not the cause of the bulk of this sell-off.

Another example of an oversold bond is Geokinetics.

This bond has a 9.75% coupon and was selling last spring for par, or $1,000. It has a maturity of just less than three years, December 15, 2014, and is way over sold. It’s priced at about 71, or $710.

At 71 it will pay par at maturity, or $1,000 per bond, or about a 41% return. The current yield is 9.75% divided by the cost of 71, or 13.73%.

13.73% a year from a bond that was selling for par last spring plus 41% at maturity! That’s a deal and a half!

About the only thing better than earning 13.75%, or 20% plus, for the next few years is getting the capital gains even sooner. That’s exactly what I think will happen. Here’s why.

Already Priced In…

First, Treasury officials from the U.K., Canada and Japan along with the Bank of Japan have all stated in recent articles that restricting banks from owning and trading bonds will hinder liquidity in the bond markets, undermine growth, have an adverse effect on government bond trading and cause a funding drought.

Obviously the big banks here at home have been saying the same thing since the idea was introduced, but hearing it from outside third parties should carry more weight with legislators.

Second, most of the people I know in the bond business don’t think the limitations on banks owning and trading bonds will happen; it doesn’t make any sense. It has too many negative effects on the markets, the economy and banking.

For small-issue bonds, the market has already priced in the worst-case scenario. That’s the best news I’ve heard in years!

This is a once-in-a-decade opportunity. While these aren’t the highest rated bonds I’ve ever mentioned in this column, both are worth more than their current price. Just holding them for several interest payments and whatever capital gain you could realize this year alone would put you light years ahead of just about any other investment out there.

Unlike any other investment, bonds have that nice little extra feature called a maturity date. That makes them so much easier to own when they’re down. It gives you a light at the end of the tunnel.

I wish I had a dollar for every client or reader who has ever said to me, “I know it’s down, but I don’t care. I will collect the interest and just hold it to maturity.”

In the case of the Alion and Geokinetics bonds, you could do exactly that. Just leave them alone and collect the money.

Aren’t bonds wonderful?

Good Investing,

Steve McDonald

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