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HOW TO MAKE MONEY WITH JUNK BONDS
By ROBERT LEVINE
The McGraw-Hill Companies, Inc.Copyright © 2012Robert Levine
All rights reserved.
Junk Bonds and Strong Horses
Greece does it; so does General Motors. So do Gannet and Goodyear Tire.
What do they all have in common besides names that start with the letter G? They all issue junk bonds.
Junk bonds are not the scary or second-rate securities their name evokes. They are not the bond equivalent of penny stocks (thinly capitalized start-ups that, more often than not, flame out). Their reputation is worse than the reality: junk bonds often provide a higher return to investors than their investment grade brethren. The companies discussed in this book are all real companies whose stock you might own.
The extent to which junk bonds are central to the U.S. capital market is surprising to most people. According to J.P. Morgan, the junk bond market is huge: over $1 trillion. There are more than 1,000 junk bond issuers. Many of these companies also issue public stock. The bonds of these companies are attractive investment alternatives to the stocks for two reasons: First, the bonds typically provide a steady stream of interest income to the maturity date. Second, in the event that a company faces financial stress, the bonds are senior to the equity (stocks) so the investor has a greater chance to recover on an investment. Many sophisticated pension funds, both state and corporate, have allocated substantial money to this sector. Junk bonds can also enhance portfolio returns.
Junk bonds are debt securities issued by a corporation that has been rated below investment grade by the major rating agencies. When I talk about this market, I will use three terms interchangeably: junk, high yield, or speculative grade bonds. Generally, these bonds have higher yields, between 2% and more than 10% above the risk-free rate of U.S. Treasury bills, and they have a higher failure rate than higher-rated bonds. They are issued by many companies, including those that are well established and play a significant role in the U.S. economy.
You may wake up on a Sealy mattress, shower with Selsun Blue (Chattem Corp.), or brush your teeth with toothpaste bought at a Rite Aid. Hungry? You may have cereal purchased at a SUPERVALU or an A&P or the Pantry. Do you want to put a banana in your cereal? It could be delivered by Chiquita Brands. Juice? Try Del Monte or Dole. Don't want cereal? Go to Denny's for eggs with bacon from Smithfield Foods. To get there, drive in a Chevrolet (General Motors) or a Chrysler or a Ford. Is it cold in your house? Call Public Service of New Mexico. While making that call, use a FairPoint Communications line, or a Cincinnati Bell telephone line, or maybe even a CenturyLink line. Every one of these companies mentioned issues junk bonds.
The airline industry is dominated by junk bond issuers. The telecommunications industry—wireline and wireless—has many junk bond issuers too. The older and most prominent automobile rental companies, Hertz and Avis, issue junk bonds, as do some prominent waste management companies. Retailers such as Dillard's, Ethan Allen, J.C. Penney, Saks Fifth Avenue, Sally Beauty Supply, and Pep Boys are all junk bond issuers. Ever go gambling? If so, it is likely you have played tables at a casino owned by a company that issues junk bonds (the gaming sector is full of them): Boyd Gaming, Las Vegas Sands, the Mirage (MGM Resorts International), Penn National Gaming, and Wynn Resorts. Need medical help? Try junk bond issuers HealthSouth Corp., HCA, Alere, and Tenet Healthcare.
Junk bonds are now part of the investment landscape, and you ought to understand the merits, risks, and returns of this asset class. What follows is my Strong-Horse Investing Method for navigating through this market. I also discuss the junk bond advantage and some potential problems to avoid.
The Strong-Horse Method is value investing for bonds in which a credit analysis of a corporation is performed for the purpose of calibrating how strong or weak the company's financials are. I relate that calibration to the price the bonds should trade at and look for what I perceive to be market inefficiencies. I call this Strong-Horse Investing because it describes the image of the type of company I look for when investing in junk bonds. A company with a powerful business that is a market share leader and low cost producer. A Strong-Horse company is in control of its future and able to generate excess cash flow to pay down debt over time and spend for the future. Such a company has a competent and ethical management team and ownership structure. Importantly, its sales and profits are rising, and it does not have too much debt. Finally, the value of the company must be worth more than the debt it has on its books.CHAPTER 2
My Son's Friend Millie
Riding a bicycle and carrying a messenger bag, my son's friend Millie weaves around town delivering packages and letters for a fee. Millie is the talk of the town, always with money for the movies as well as a bag of popcorn; she enjoys an active social life. Millie is in fat city. She makes $10 a day, five days a week, for half of the year. She works only half of the year because the weather is too bad to ride her bike during the other half. Therefore, her revenue is $1,300 per year. Unfortunately the bike is old and frequently breaks down. Millie is afraid that if she cannot fix her bike, she will lose customers. She can make only two deliveries per day, but sometimes she has the demand for three or four. So many people want her service that she may want to buy a second bike and hire a second rider. A new bike costs $200, and a bike repair costs $100.
Millie has asked my son to lend her $300 to both fix the old bike and buy a new one. My son is afraid that if he lends her the money, Millie may not repay him or she may take too long to repay him. Millie does not know how to work on bikes herself, and she always has to take them to the shop to be fixed. Getting her bike fixed takes time, and she may lose customers since she won't be able to make deliveries while her bike is in the shop. Millie may not have enough new customers to justify the cost of buying a second bike. She also faces the risk that her new employee will simply run away with the bike. Currently, my son is holding his money in an interest-bearing account in the bank, meaning he has opportunity costs. If Millie doesn't pay him something for the use of the money, he is actually losing money himself—the interest from that bank account.
My son needs to figure out how long it will take Millie to repay him so that he can determine whether a loan is worth making. Let's say that Millie makes $5 per delivery and that she makes two deliveries a day. If she keeps this up, she should be able to pay my son back in 30 business days ($10 x 30 days = $300):
If she gets a second bike, she must hire someone to make those extra deliveries. Millie decides to post an ad in the classifieds for a bike messenger position at a wage of $5 per day.
If the new messenger makes two deliveries in a day, Millie will make $5 ($10 from deliveries - $5 wage = $5).
However, if the new messenger makes only one delivery in a day, Millie will not make any money. Instead, she will break even ($5 from deliveries - $5 wage = $0).
Further, if the new messenger has no delivery requests in a day, she will lose $5 because she will still have to pay him for idly waiting for messenger requests ($0 from deliveries - $5 wage = –$5).
My son must also weigh the competitive nature of Millie's business. With no barriers to entry, anyone with a functional bike could easily enter the bike messenger market, cutting into Millie's business and cu
Excerpted from HOW TO MAKE MONEY WITH JUNK BONDS by ROBERT LEVINE. Copyright © 2012 by Robert Levine. Excerpted by permission of The McGraw-Hill Companies, Inc..
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