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A New Strategy for High Income Investing With Ultra-Low Risk

Interest-Rates / Corporate Bonds Dec 03, 2012 - 12:07 PM GMT

By: Investment_U

Interest-Rates

Steve McDonald writes: The Wall Street Journal recently ran a segment about a fund that’s trading high-yield corporate bonds with virtually no risk! All compliments of a fold in the bond market that has been staring at us for the last hundred years – and no one noticed it.

This type of corporate bond is essentially pre-refunded. That means the money to buy the bonds back is already set aside, and the buyback date is already set – in some cases in as little as a week.


There’s virtually no risk!

Better yet: These bonds have a maximum of about a 90-day holding period, some as short as five days. And this very limited amount of market exposure means iron-clad protection from inflation and a market sell-off.

Sounds like an infomercial I know, but this is real. I’m embarrassed I didn’t think of it first.

Most corporate bonds are issued with call features that allow the company to buy them back before maturity. Bonds are called if the company has a lot of cash and wants to reduce its debt load, or if interest rates have dropped significantly and it can refinance the bonds at lower rates.

Both are signs of a solid company.

Right now is an excellent time to get high-cost debt out of circulation, but many bonds either don’t have a call feature built in, or the call is farther out than companies want to wait.

Remember, every day a bond stays on the market costs the company lots of money in interest expense. So every company that has the ability is getting rid of its debt or reducing its interest expense by buying back or reissuing bonds.

Receiving a Tender Offer

Essentially, a tender offer is when a company doesn’t have a call feature available and offers its bond holders a special, one-time deal to buy the bonds back early.

When the tender offer is made, the market price of the bond runs up to the offer price. The bond holders have a set amount of time to respond to take advantage of the offer, and if enough bond holders agree to it, it goes to settlement in anywhere from five to 90 days.

Here’s where it gets interesting!

Between the time the tender offer is made and settlement date, the bond continues to pay interest.

What we have is a bond that has had money set aside to buy it back, always a good sign of the health of a company, and anywhere from five to 90 days of interest before the settlement date from what is essentially a pre-refunded bond.

The buyer of this type of bond not only knows when he will get his principal back, but also that the money is already there to buy it back. Best yet, he gets his accrued interest until settlement.

How could we have missed something this good?

The answer: Until we got into this horrible yield market, no one really needed to look at this type of trade. CDs and savings were paying enough to pay the bills, and no one was interested in stretching the envelope.

Everyone is stretching it now…

An Example of a Tender Offer

Here’s a tender offer from one of the bonds in my Oxford Bond Advantage Portfolio that would have been a great short-term return.

Massey Energy had a 3.25% bond selling at about 88 when we originally bought the bond in August. They made an early tender offer in September of 94, $940 per bond, and a regular offer for the late comers of 92, $920. Two offer prices – a regular and an early – aren’t unusual in a tender. And our return was almost 7% with a holding period of just 53 days.

But, if you bought the bond for 94 – which is what it was selling for after the offer was announced – you would have collected 3.45% annually for each bond you held. And although this wasn’t even close to our highest-paying bond, it wasn’t a bad investment.

A CD of the same holding time is paying virtually nothing. Based on our cost of 94, the current yield of 3.45% is way above anything else available. Treasuries of the same duration pay less than 1%.

A bond that’s inflation and sell-off proof in this market, with any kind of yield, is invaluable!

But, there are a few negatives or gray areas to this strategy…

Things to Watch Out For

First, some of the holding times can be as short as a week. Some can run for 90 days. It’s a function of the settlement date and how quickly the company wants to get the bonds out of circulation.

Next, there may only be two or three tender offers per month in the whole corporate bond market. So you’ll have to stay on top of your broker or his bond desk to get in on them.

This will also be transaction intensive. If you buy all of the available tender offers, you could have as many as nine and 12 bonds in the works at one time. They’re pretty much on autopilot after you buy them – your principal automatically shows up in your account – so you have very little to do, but it’s a lot of activity for some folks.

Most importantly, once in a while a tender offer doesn’t have enough participation and the company will pull it. In that case, you would own the bond until a call or maturity.

One precaution is to wait for a few days after the offer and check with the bond desk to see how the redemptions have been doing. Make sure there have been enough bonds tendered to make the deal viable. You’ll lose a few cents in interest, but you won’t get locked into a long-term commitment.

This strategy isn’t for everyone. You’ll have to invest a lot of cash to make it worthwhile, but you can’t argue with the annual returns compared to the risk.

It’s not my style to describe anything in this business as a “no brainer,” but I’m having trouble finding anything wrong with this strategy. It’s actually one where you could play a lot of money over several plays at a time and watch the small gains add up.

Pre-refunded, an ultra, ultra-short holding time, returns way above anything else of the same duration and a virtual guarantee.

This is a very new concept to both pros and beginners, so move slowly and keep your ear to the ground. In this yield-starved market, this could really catch fire.

And remember: Never get piggish, even with a gimme.

Good Investing,

Steve McDonald

Source: http://www.investmentu.com/2012/December/high-income-with-ultra-low-risk.html

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