Triple Your Expected Return

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

Bond Investing

Doing something as simple as focusing on the fundamentals of a corporate bond rather than its interest rate will return three and four times what the average income investor is earning.

But virtually no one does it.

That’s too bad, because the same average income investor has starved for yield for more than six years. Junk bonds, usually the highest paying of all bonds, are paying only about 3.3% more than government-guaranteed Treasurys.

Historically speaking, these numbers are ridiculously low.

If that isn’t bad enough, yields on every type of bond are expected to move even lower.

A Rock and a Hard Place

Rates are going lower because, despite this tough market, buying pressure in the high-yield area is increasing steadily. It’s increasing because there is nowhere else to go.

The rates on traditional havens for safe income – bank CDs and savings – are so low they aren’t worth the paper they’re printed on.

Treasurys are at levels so low that only those required to own them can buy them without feeling foolish. Who else would want an annual return of 3.4% for 30 years? That means you will earn a whopping $34 a year from a $1,000 bond with a 30-year commitment. That’s nuts!

And municipal bonds are paying so little that even with their tax breaks, they don’t add up to nearly enough income either.

It’s not a pretty picture. But there is opportunity in corporate bonds. And if you are willing to rein in the “rate pigitis” that drives most income-buying decisions, you can turn a tough rate environment into big returns.

Investing in the Turnaround

The first thing you have to do to make a decent return in bonds is to be able to look beyond the coupon and the yield to maturity. That’s about all most people consider when investing in a bond. They couldn’t be more wrong, and it is costing them a lot of money.

In the bond portfolio I manage, the biggest returns we have this year are from the bonds that had some of the lowest annual yields when we originally purchased them.

Consider this trade we just completed in a Cooper Tire & Rubber Co. bond.

We bought the bond on January 29 of this year at about 110. That’s $1,100 per bond, a $100 premium. Most stockbrokers will tell you not to pay a premium for a bond because it pays only $1,000 at maturity and you lose the added principal (in this case, $100).

They’re wrong! The really good bonds with good capital gain potential are all selling at premiums.

This bond had an 8% coupon, which in today’s market is huge. But since we paid a premium, our real income from the bond was 7.2%, or 8% divided by $1,100. Our annual return to maturity at purchase was just 5.7%.

Both numbers are lower than they would be at $1,000 per bond because of the premium. The stockbroker’s advice is beginning to look pretty good, isn’t it? Who would want lower income than the coupon and a lower annual return too?

Wrong again!

What most people miss about corporate bonds is that their prices follow the underlying fundamentals of the company much more than interest rates. So if things improve for Cooper Tire, its bond price moves up.

That’s exactly what happened.

Not long after we bought the bond, Cooper Tire announced all kinds of new long-term plans. The market loved them and the bond responded accordingly.

It announced plans to:

  • Increase annual profit margin by more than two percentage points.
  • Reduce manufacturing costs by 14% between now and 2017.
  • Reduce the number of global products by 60%, which will save money and simplify the business.
  • Launch a record number of new products this year in the U.S.
  • Improve margin and mix on the back of sales growth and product launches.
  • Focus on premium products and expand into markets with relatively low penetration.

The effect of all this drove the price of our bond from 110 to 114, or $1,140.

That may not seem like much. However, since bonds pay their interests from the day you take possession, not on an ex-dividend date, we also earned five months of interest. The capital gain and interest pushed our annual return from 5.7% to 15.9%.

Here are the numbers:

$33 + $40 / $1,100 / 5 months x 12 months = 15.9%

We took a capital gain of $40 per bond, and the interest for the time we held the 8% coupon was $33. That’s $73 per bond in less than five months.

When we bought the bond, we expected to make an annual return of 5.7%. By selling it before maturity, actually just five months after we bought it, we increased our annual return to 15.9%.

That’s just shy of three times what we expected to earn.

And, just so you don’t go away thinking this was a fluke, we took profits on two other bonds the same day as the Cooper Tire trade, earning 200% and over 400% more than our original expected returns on the pair.

We have taken profits like these 15 times in 2014 alone.

But, as I said, virtually every income buyer looks only at the coupon and/or the yield to maturity and ignores the capital gain potential in bonds. And that’s where a lot of the money is made in corporate bonds.

The part everyone misses, especially the money press, is that the market price of corporates is tied to their fundamentals, not interest rates. If fundamentals improve, the market runs up.

As the balance sheets of companies continue to improve in this near-zero interest rate environment, bond prices will continue to move up.

Add the increased buying pressure from a yield-starved market and you have the making of lots of trading opportunities that will increase your expected return as much as 400%.

Oh, and beyond the fact that corporate bond price changes are tied to fundamentals, they are also less volatile than Treasurys and municipals when rates go up.

But that’s for another article.