Editor's note: Most investors stay away from bonds... Investing in a company's debt might sound scary. But according to Porter & Co. senior analyst Martin Fridson, if you let fear keep you out of the bond market, you could miss out on huge gains... In short, Martin says bonds are actually far safer than stocks... and can offer better returns, if you know what to look for. After all, with this type of investment, companies are legally obligated to pay you – even if their share prices drop. But to find the best distressed-debt opportunities, you must understand how to determine the ideal time to "pick up the scraps"... In today's Masters Series, adapted from the January 26 issue of Distressed Investing at Porter & Co., Martin explains everything you need to know about distressed-debt investing... details the most important factors he looks for in a distressed-bond investment... and reveals how you can apply this strategy to your investment playbook today...
How We Learned to Stop Worrying and Love Bankruptcy By Martin Fridson, senior analyst, Porter & Co. In Stanley Kubrick's 1964 Cold War comedy Dr. Strangelove, General Jack D. Ripper resorts to drinking distilled rainwater so that the Communists won't pollute his "precious bodily fluids" with fluoride. To some Distressed Investing readers, studying the mechanics of bankruptcy seems about as appealing as drinking that rainwater. After all, readers might ask, why invest in a company that has a realistic chance of going bankrupt – doesn't bankruptcy mean you lose everything? Actually, that's not the case – for two reasons. First, some of the best distressed-debt opportunities arise in bonds of companies that have already filed for bankruptcy – which, critically, does not mean the companies are going out of business, but rather that they are entering formal legal proceedings to restructure their debt load. While the company attempts to straighten out its financial affairs and is paying no interest to its creditors, its bonds can be bought at knockdown prices. There may be immense uncertainty about how much of their original investment – usually $1,000 face value per bond – the holders will recover in the end. The prices may be so low that an astute investor who buys at that point could reap a gain of 100% or more when the company emerges from bankruptcy. So to get a solid grasp of our analysis of this kind of opportunity, it's important to follow the arguments we present with the U.S. Bankruptcy Code as our framework.
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Second, even if you buy a bond that's in good standing – current on all of its scheduled coupon payments – the bond's market price is still impacted by expectations about how bankruptcy would play out. Unless a bond is an obligation of the U.S. Treasury, the market assumes it has some probability of default, however small. According to historical data compiled by credit-ratings agency Moody's from 1983 through 2022, even a AAA credit has a 0.1% chance of failing on its debt within five years. That kind of number isn't going to keep bondholders awake at night. But we have to consider the other end of the rating spectrum. A company rated Caa (which is near the bottom of the speculative grade or "junk" category) has a 30% chance of defaulting within five years, according to Moody's. Over a 10-year holding period – with a 47% probability – a Caa company is almost as likely to default as not.  If you buy at the right time and at the right price, you can get paid extremely well to take that kind of risk. For example, the average bond in the ICE BofA U.S. High Yield Index produced a 91% one-year return, beginning from the midpoint of the 2020 recession. (Bonds rated Caa by Moody's, or the equivalent CCC by Standard & Poor's, accounted for half of all distressed issues at that time.) So how does the possibility of bankruptcy affect the price of a bond, even if it's not in bankruptcy? Here's an illustration... Suppose company "XYZ" has a huge amount of debt – relative to its ability to service that debt with cash flow – and it's coming due three years from now. Analysts see a substantial risk that the company will be unable to obtain new financing at that point, without which it won't be able to repay the principal on the maturing debt. That will cause the company to default on its bond issue and file for bankruptcy. Let's also suppose the market sets the probability of XYZ's bond defaulting in three years at 50%. In today's market, the bond's risk premium – defined as the yield difference (or "spread") between the bond and default-risk-free Treasury bonds – would have been about 22 percentage points – or 2,200 basis points. That's the median spread for bonds rated in the rock-bottom Ca-C rating categories by Moody's. Companies rated Ca-C have a 53% chance of defaulting within three years, according to Moody's. But what if the collective wisdom of investors is wrong? Let's suppose skilled analysts' more realistic estimate of the company's chances of going belly-up when the big debt bill comes due is only 20%, rather than the 50% likelihood assumed by the market. In that case, the spread should have been around seven percentage points, which is the current median spread for Caa bonds. Companies in that category have a 20% chance of defaulting within three years. In this situation, we'd alert readers that we believe the XYZ bond yield is higher than it ought to be, meaning that its price is lower than it ought to be. Pouncing on the opportunity isn't without risk, but you're getting paid more than fairly for the risk. Over time, buying distressed bonds that are trading cheaper than their actual risk justifies will pay off richly – even though some of them will default, despite that being judged the less-probable outcome. Depending on the circumstances, we may recommend taking the loss at that point and moving on. The key point is that the possibility that the issuer will "hit the fan" makes a difference in valuing its bonds. Getting to the right value requires knowing what's likely to happen to the various creditors who will vie to pick up the scraps. Fasten your seat belt to prepare to take advantage of upcoming opportunities in distressed debt – especially if the market's current expectation of a soft landing proves to be a mirage. Keep in mind that most high-yield bond issues have a long way to fall before they become interesting to distressed investors. The distress ratio ended 2023 at just 6.4%, a low level by historical standards. Only about one in 16 speculative-grade bonds currently has a yield spread-versus-Treasurys of 10 percentage points or more, signaling a substantial risk of default within the next 12 months. We will be keeping an eye on the distress ratio throughout the year and on the bonds whose yield spread versus Treasurys exceeds 10 percentage points. It's in this group where we can find good pickings for the year ahead. Good investing, Martin Fridson
Editor's note: This credit cycle isn't the only situation we're closely monitoring right now. You see, Stansberry Research founder Porter Stansberry believes this collapse could set the stage for a massive financial reset... Porter says this market shift could result in a historic moneymaking opportunity for investors who are paying attention. That's why he recently went on camera to reveal how investors can take advantage of this unique setup. Click here to catch up on the full details... | 
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