2/14/17, 5:34 PM

INCOME PORTFOLIO

Special Reports
The Complete Corporate Bond Investing Primer
January 30, 2017 Special Reports

Most investors don't know it, but the U.S. financial system suffers from a major flaw.

And we believe that flaw is giving us the opportunity over the next few years to make MORE
money with corporate bonds than with stocks, while avoiding much of the uncertainty that
goes with investing in ordinary equities.

What's going on here?

As you know, most bonds pay a safe, secure, and (usually) small return... typically between 5%
to 10% per year.

But some of America's best companies will be offering bonds that are legally obligated to pay
you 10 to 20 times bigger returns – often with less risk than stocks.

It all boils down to the way the U.S. government regulates the corporate bond market.

You see, unlike stocks – which are analyzed by thousands of market participants every day, and
which can go up or down in price depending on factors like buying volume, insider activity,
earnings announcements and so on – corporate bonds are analyzed and rated by two main
government-authorized ratings agencies: Moody's and Standard & Poor's (S&P).

Moody's and S&P control approximately 80% of the bond-ratings market. These agencies use
sophisticated computer models and simulations to determine whether a company can meet its
obligation to pay us. Depending on their ratings (which can range from "triple A" to "triple C"),

https://members.stansberryresearch.com/post/87199 Page 1 of 18
 2/14/17, 5:34 PM

the market determines what price to pay for a particular bond.

But here's the problem: The models Moody's and S&P use can be wrong. This can lead to
dozens, or maybe hundreds of mispriced bonds at any given time.

For example, prior to the 2008 global financial crisis, both agencies gave Lehman Brothers an
"A" rating – meaning it was a safe investment – right until Sept. 15, the day Lehman filed for
bankruptcy. They also gave safe "A" ratings to complicated subprime mortgage bonds, which
were at the core of the financial crisis.

Very simply, because of these anomalies in the market you can often lock in 100%-plus returns
on certain bonds – without worrying about whether the markets go up or down.

You won't have to worry about stocks going up or down for the next few years. No matter what
happens to the economy or to a company's stock, as a bondholder you will always be further
ahead in line to get paid. And that's the bedrock of our bond-trading philosophy.

Let us explain...

Why You May Never Buy a Stock Again

We hope you're ready to start investing in a manner that is completely unheard of for the vast
majority of individual investors... a manner that has an amazingly simple philosophy: We get
paid first.

For most people, bonds are an unfamiliar style of investing. So, let's take a minute to explain
the basics.

Like stocks, these bonds allow you to invest in some of the best companies in America. But
unlike stocks, you'll always know exactly when and how much you'll be paid.

Investing in the bonds we're going to tell you about is as profitable (or more so) than stocks...
comes with less risk... and provides you an exact date on which you'll be paid. As you'll learn,
it's us, the company's bondholders, who hold a priority claim legally, to a company's income
stream. Stockholders often come in around eighth in line.

We look to double our money in these safe and stable bonds... often in a few short years. Most
common-stock investors are lucky to make a fraction of that return consistently.

https://members.stansberryresearch.com/post/87199 Page 2 of 18
 2/14/17, 5:34 PM

Below, you'll find the what, why, and how of being a bond investor.

What We Do
We look for two major things with our bond investments: safety and a high return.

When a corporation needs money to pay bills, expand, or upgrade equipment, it can fund these
activities with the cash coming in the door, by issuing stock (also called "equity"), or by
borrowing the money by issuing debt. This is also called "issuing bonds."

As an owner of a company's common stock, you share in the company's future profits. If you
own stock in a company that grows its profits by a factor of 10 over a few years, chances are
good your stock will be worth a lot more than your original purchase price.

As a bondholder, you have no claim on the company's profits. You are simply loaning money at
a set rate for a predetermined period of time. You are entitled to get your money back plus
interest payments according to a federal statute that governs bond agreements.

Most people find it incredibly difficult to consistently select stocks that grow their profits (and
stockholder's equity) over a long period of time. For every huge success like Apple, Starbucks,
or Home Depot, there are scores of bankrupt dreams. And when a company goes bankrupt, the
stockholders can lose every cent they have in the company.

This is why we love being a bondholder. In the event the company gets into trouble, the
bondholders are at the head of the line when it comes to paying bills and creditors. And in the
event of an all-out bankruptcy, the assets of the company are sold, and the proceeds are paid to
the secured creditors and bondholders.

This legal right to be paid is the bedrock of our bond-trading philosophy. As

bondholders, we don't have to guess who has the best widget or which style of clothing people
will like from year to year. We just loan money. We simply have to tear through a company's
books and determine if it can pay us off in the time period our bonds are "in play."

Why It's Possible to Do This

Economic theory says we have to take on greater risk to earn greater returns.

We disagree.

https://members.stansberryresearch.com/post/87199 Page 3 of 18
 2/14/17, 5:34 PM

The stock and bond markets make temporary mistakes. Even the smartest investors can get
carried away with their fear and greed... which leads to the "mispricing" of risk.

If risk were always properly priced, there would be no investment opportunities for us to tell
you about. Investors like Warren Buffett wouldn't be able to buy cheap assets and earn huge
returns.

The high returns we can earn are possible because of a significant mispricing of risk. And the
market is littered with bonds mispriced by the majority of investors, both professional and
amateur.

Two factors create this mispricing.

First, most big bond-market participants – like insurance companies and pension funds – can't
buy the types of bonds we're focused on. These institutional investors are prohibited from
investing in the part of the bond market where we generally work.

This market is commonly known as the high-yield, or "junk," bond market. A high-yield bond is
considered riskier than bonds called "investment grade." Don't worry though... as we'll show
you in a moment, we'll use this perception of increased risk to make a lot of money.

This lack of "big competition" in the high-yield bond market lets us find great deals
without much competition.

Think of it like this... if you're one of the few mortgage lenders in a town, you could be very
picky about the loans you extend to borrowers. You don't have much competition, so you could
demand high rates of interest and plenty of collateral to back your loans.

Second, the high-yield market is relatively small and carries a stigma of low quality, which is
not always deserved. The quality of a loan is determined by analyzing each individual
borrower. As we mentioned, Moody's and S&P sometimes make errors in rating bonds, leading
to mispricing in the bond market. Wall Street simply bypasses the forest and leaves a lot of
strong trees for us to investigate without much competition.

The bonds we buy could be called "contrarian bonds." Much like a share of stock, a bond can be
sold by investors who are afraid of holding the asset. For instance, you could buy a contract
that entitles you to a payment of $1,000 from a company for just $800.

https://members.stansberryresearch.com/post/87199 Page 4 of 18
 2/14/17, 5:34 PM

That's right. You pay $800 and get paid $1,000. Plus, you receive interest payments while you
hold the bond. Here's how this is possible...

How to Make the Biggest Gains in Bonds

Just like stocks, bonds trade in a public market that is heavily influenced by emotions.

And just like stocks, emotions can cause bonds to trade for less than their true value.
Professionals call this true value the "intrinsic value."

When investors become concerned about a business or industry, they're willing to pay less for
the debt obligation of that business... just like they're willing to pay less for a dollar's worth of
earnings of that business.

Let's say company ABC borrowed $5 million three years ago by issuing 5,000 bonds worth
$1,000 each. (Most bonds are issued at $1,000 per bond. This original issue price is called the
"face value.")

The company agreed to pay its creditors 8% interest for five years. That's an interest payment
of $80 per bond each year. The amount borrowed, the interest rate, and the life of the bond can
vary greatly. But we're keeping it super simple for our example.

Now... let's say ABC is struggling due to new competition or an industry downturn. The bonds
ABC issued that originally had a value of $1,000 will fall. Investors aren't as rosy about the
company's prospects... so they're only willing to pay $800 per bond.

Here's where it gets profitable for you...

We do a thorough analysis of ABC. We know the company will generate enough cash to pay the
interest it owes to its creditors. (Remember, the creditors are first in line to get paid.
Shareholders could see their cash dividend disappear.) We buy ABC's bonds for $800 per bond.
That 8% interest on the original value must be paid.

Since we bought the bonds for $800, our $80 in annual interest payments gives us a yield of
10% per year. Now come the capital gains...

ABC has to pay off all of the $5 million it borrowed in two years. (Remember, the bonds were
issued three years ago.) It is contractually obligated to pay $1,000 to the holder of each bond.

https://members.stansberryresearch.com/post/87199 Page 5 of 18
 2/14/17, 5:34 PM

Since we took advantage of the pessimism toward ABC and did a thorough analysis of its ability
to pay its debt, we are rewarded with a 45% gain on our original purchase price. We paid $800
for the bond, earned $80 in interest each year for two years ($160 total interest), and we make a
capital gain of $200.

Here's how the math works out:

1. Bought ABC bond for $800.

2. Collected $160 in interest payments.

3. Received $1,000 when ABC paid off the total debt.

4. We make $360 off our investment of $800 – a 45% gain in two years.

How We Know It's Safe

The biggest key to making these large, certain, timely gains is our ability to perform a solid
credit analysis of each and every position.

Our bonds must be safe. With all our recommendations, we know the bonds are safe because
our analysis says the borrower has adequate resources to pay us. We ensure the company has
sufficient assets to pay off our bonds even if it should fall into bankruptcy and be liquidated.
That's our job.

You see, bonds become deeply discounted because of credit downgrades. A credit agency like
Moody's or Standard & Poor's has analyzed the borrower and lowered its opinion of the
company's credit quality. Downgraded bonds decline in price because the risk of a borrower
default is higher.

However, we will not recommend a bond unless we are satisfied the borrower has enough
resources to pay the interest on the bond and redeem it at maturity. And frankly, our bond
recommendations will be safe because they will have already declined in price. The only
reasons for a significant further price decline are that investor confidence in the company's
ability to repay its debt wanes or a default. And as we said, the value of the borrower's assets in
liquidation is enough to pay us.

We look for complete coverage of the face value of the bond. This means we have an excellent

https://members.stansberryresearch.com/post/87199 Page 6 of 18
 2/14/17, 5:34 PM

possibility of not only recovering our investment, but of receiving the full value of the bond.

Safe, high-yield bonds... that's the core of our strategy. Once you understand how
powerful this investment strategy can be, you may never buy another stock again.

How to Choose a Bond Broker

Buying a bond is a little different from buying stock. But once you get the hang of it, you'll see
it's easy.

Please remember that discounted bonds, in general, have wide bid/ask spreads. The bid/ask
spread is the difference between the price at which buyers are willing to purchase a security
and the price at which sellers are willing to part with a security. Big companies like Home
Depot have plenty of buying and selling interest in their equity, so the difference in bid/ask
prices is miniscule.

Bonds, on the other hand, often have little buying and selling activity. They're also not always
"one click and you're done" investments. Depending on your broker and the bond you want to
buy, you will be able to buy some bonds online. But you may also have to call your broker and
tell him to buy the bond for you. Therefore, most brokers won't be crazy about making the
transaction. It's more work for them. It's not "big volume, big business" Wall Street fare. They
may even try to talk you out of buying high-yield bonds because it's an unusual activity for the
average investor.

We like it that Wall Street looks at it this way... It means that we're not dealing with lots of
competition to find the best deals. Remember our mortgage lender example from above...

So when you call your broker, ask him for a current market indication. That's the bid offer,
essentially what price you can buy this for today. And ask about the availability of the number
of bonds you want to buy.

If you want to buy a small position, he may be able to fill your order right away. If not, consider
dividing your position into several orders. This means you will need to call your broker for each
order. Most brokers will charge a commission of $1 per bond purchased (subject to a minimum
– depending on your broker). You'll also pay $1 per bond when you sell.

Your broker will very likely have to call a fixed-income specialist in his firm in order to get you

https://members.stansberryresearch.com/post/87199 Page 7 of 18
 2/14/17, 5:34 PM

a quote. We have talked with the fixed-income specialists at both Schwab and Fidelity.

The specialists go to their screens to check the dealers who are making a market in this
particular bond. In some cases, different dealers offer a bond, with slightly different prices and
amounts available. Both specialists told us these were indications only, and greater volume
may exist behind what the dealers are showing.

They also cautioned against shopping this with different brokers, which is valid advice. For
example, if we called three brokers and asked for a quote on a bond, each broker would go to
the same dealers. It would appear to the dealer that there is three times more demand than
there truly is. This may cause the price to go up. That's why we advise you to deal with a broker
you know and trust.

We don't recommend brokers, but if you don't have broker who can help you buy fixed-income
instruments, we suggest you use a large and reputable company to make these trades. Here are
the names and contact information of three national firms that advertise fixed-income
expertise. Ask for the fixed-income specialist.

Bond Brokers

Charles Schwab
866-232-9890 www.schwab.com

Fidelity Investments
800-343-3548 www.fidelity.com

TD Ameritrade 800-669-3900 www.tdameritrade.com

The major "market makers" in bonds, called dealers, are firms like JPMorgan, Goldman Sachs,
and Morgan Stanley. These investment banks and others originate new bond issues, called
underwriting. This means they stand ready to either buy or sell a bond they have underwritten.
They guarantee there is a market for the bond.

While the bid/ask spread depends on a number of factors – like trade size, rarity, credit rating,
interest rate and so on – we think a working estimate of a typical dealer spread for our bond
recommendations is about "five points." This means they will sell you a newly issued bond for

https://members.stansberryresearch.com/post/87199 Page 8 of 18
 2/14/17, 5:34 PM

$1,000, and they will buy it back at $950. The spread is $50, or five percentage points.

This is much higher than the bid/ask spread for stocks. This is why it is important to use your
broker to find you the best price. With bonds, we are much more focused on the price to buy
than the price to sell, because we plan to hold these bonds until the borrower pays the full
amount of the bond, which is $1,000.

Appendix
We know you may be new to the world of bond investing. So we've compiled this guide to some
of the basic tools and terms you'll need. Section I is structured as a "Q&A" on bonds. In this
section, you'll learn the answers to some basic bond questions.

Section II and III are essays that detail some of the things we've learned from our experience in
finance. Section IV is a bit more technical. It will give you some basics on how interest rates
are determined for all types of borrowers. Don't worry... you won't need to memorize any of it
to make a lot of money in bonds.

I. Bond-Investing Basics
What is a bond?
A bond is a loan. Three different types of borrowers use bonds: governments, municipalities,
and corporations. We will be making loans to corporations.

A key difference between stocks and bonds is that stocks make no promises about dividends or
returns. The company is under no obligation to pay you.

However, when a company issues a bond, it guarantees it will pay back your principal (the face
value) plus interest. If you buy the bond and hold it to maturity (when the loan expires), you
know exactly how much you're going to get back. Bonds are traded in $1,000 increments. So for
each bond you buy, you'll receive $1,000 at maturity.

When we make a loan, we want to know four things:

1. What is the amount of the loan?

2. Who is the borrower?

3. How much interest do we earn?

https://members.stansberryresearch.com/post/87199 Page 9 of 18
 2/14/17, 5:34 PM

4. When do we get paid?

Let's use an example bond called ABC Company 7.86% bond due 8/15/2018 to illustrate how
this works.

You decide the answer to the first question. You decide how much money you want to loan.

The "face value" of each bond is $1,000. That's also called its "par" value. But that's generally
not what we'll pay for our bonds. For example, if the ABC Company bond was selling for $740,
and you wanted to invest $10,000, you would buy 13 bonds ($10,000/$740).

The next three are answered in the description of the bond: ABC Company (borrower) 7.86%
(coupon) bond due 8/15/2018 (repayment date):

ABC Company is the borrower. That's easy. The next question – how much interest do we earn
– is a little tougher.

The "coupon" is 7.86%. This is the interest the borrower pays on the loan... But it's not
necessarily the interest you earn.

The borrower calculates the interest payment by multiplying the coupon (7.86%) times the par
value ($1,000)... So 7.86% times $1,000 equals $78.60. This is the annual interest amount paid
in two equal installments of $39.30 on February 15 and August 15.

The coupon will not change. Bondholders are guaranteed payments equaling $78.60 a year
per bond. But the price of the bond can change. Here's what it looks like for the ABC example
bond:

Current price of the bond $740.00

Annual interest payments $78.60

Yield ($78.60 / $740) 10.60%

So if you pay $740 for this bond, you'll actually receive a 10.6% yield – much higher
than the original coupon.

The last part of the bond description is the maturity date. This is the date the loan will be

https://members.stansberryresearch.com/post/87199 Page 10 of 18
 2/14/17, 5:34 PM

repaid. The borrower borrowed $1,000 and will repay $1,000. So you will receive $1,000 for
each bond you hold.

What is my return?
When you buy a bond, you will get the interest payments, plus you'll be repaid the full amount
of the bond at the end of the loan. Your return is the combination of the interest payments
plus the capital gain amount.

We'll be buying bonds at a discount to par value. So when the bond matures, you will have a
capital gain equal to the amount of the discount. In the ABC Company bond example above,
the purchase price is $740 and the amount repaid is $1,000. Your capital gain is $260, or 35.1%.
And your interest will be $78.60, or 10.6%, a year until the bond matures.

When will I get paid?

Most corporate bonds, like the ones we'll be buying, pay interest twice a year.

The borrower pays interest to the bond trustee, who sends the interest payments to you. The
bond trustee will be an independent company – selected by the borrower – that takes care of
bookkeeping.

Do I have to pay taxes on the interest?

Yes. Unlike municipal bonds, which are exempt from federal (and sometimes state) taxes,
corporate bonds pay taxable interest to bondholders. You can get around this by holding the
bonds we buy in a tax-exempt retirement account (like an IRA).

What are the risks?

A bond manager faces many risks: interest-rate risk, event risk, default risk, credit risk,
downgrade risk, prepayment risk, duration risk, and more.

We, on the other hand, don't have to worry about most of these. We'll be buying debt that's
already discounted. And because we will hold these bonds until they mature, we eliminate
interest-rate risk and duration risk.

In fact, we face only two significant risks (and they are related)... credit risk and default risk.

If the borrower's credit deteriorates, we face the prospect of a default. If the borrower defaults,

https://members.stansberryresearch.com/post/87199 Page 11 of 18
 2/14/17, 5:34 PM

we may lose all or part of our capital. But our analysis is designed to find high yields while
ensuring that default is as remote a risk as possible.

How do I buy a bond?

There is no central place or exchange for bond trading, as there is for publicly traded stocks.

Bonds are traded through bond dealers, more specifically, the bond-trading desks of major
investment dealers, like JP Morgan and Morgan Stanley. These dealers buy and sell huge
volumes of bonds. They know all about a particular bond and are prepared to quote a price to
buy or to sell.

When you want to buy a bond, depending on your broker, you will be able to buy some bonds
online. Alternatively, you call your broker, and he calls one of the dealers to arrange the trade.
You need to give your broker this information about the bond you want to buy:

How many bonds

The name of the borrower, the coupon, and the maturity date

The CUSIP number

A CUSIP, which stands for "Committee on Uniform Securities Identification Procedures," is a

unique nine-character code assigned to every traded security. Using the CUSIP along with
the description eliminates any possibility of error, and we'll always provide the CUSIP number
when we make a bond recommendation.

Your broker will arrange the trade and credit the bonds to your account. Bonds are "book
traded," which means your ownership is accounted for and maintained by the bond trustee, an
independent company – selected by the borrower – that takes care of bookkeeping. A
certificate is not issued.

Where can I learn more about bonds?

PIMCO, the world's largest bond investor, covers the basics of corporate bonds:
http://www.sbry.co/DkKEAC

com offers prices, market overviews, and calculators: http://www.sbry.co/LtZpD1

Yahoo has a bond screener here: http://sbry.co/XCOmS

https://members.stansberryresearch.com/post/87199 Page 12 of 18
 2/14/17, 5:34 PM

FINRA (Financial Industry Regulatory Authority) has tips on how to choose a broker:
http://www.sbry.co/kSeV8B

Conversations With Your Bond Broker

While it's a little different than buying a share of stock, it's easy to buy bonds. Here's
how a typical conversation with your broker might go:

Investor: "Hi. I want to buy 10 bonds today. Can you get me a price so I can decide if I
want to buy or not?"

Broker: "Sure. What bonds are you interested in?"

Right here, the investor needs to provide four pieces of information: The name of
the company that issued the bond, the coupon, maturity date, and the CUSIP
number.

Here is an example:

Investor: "I want to buy the ABC Company 7.86% bond (or "note" – the terms "note"
and "bond" are used interchangeably) due on 8/15/2018. The CUSIP (pronounced "Q-
sip") number is 12345AB09."

Each piece is important, and your broker will need it even if he doesn't ask you for it.
Just so you know, a CUSIP is assigned to every security (stocks, bonds, convertibles,
etc.) by the rating agency Standard & Poor's. Each one is different... so the CUSIP
number describes one and only one bond. That way, there can be no mistakes.

Here are some of the broker responses you might receive:

Broker: "I am not familiar with, cannot find, that company."

"That CUSIP number is invalid."

"I cannot sell you that bond because it is not in our inventory."

None of these responses are totally accurate. They can sell you the bond. Sometimes
you'll deal with an individual broker who barely knows what a bond is. (Again, we like

https://members.stansberryresearch.com/post/87199 Page 13 of 18
 2/14/17, 5:34 PM

this... it means we're operating in a market with little interest and little competition
for deals.) Just ask your broker to contact the fixed-income specialist. The specialist
will know what to do and how to help you.

Investor: "You need to call your fixed-income specialist to help you. Please call me
back when you have a price."

Broker: "Thanks for the information. I have a price for you. The price for the size (10
bonds) you requested is $74. My firm charges you a commission of $1 per bond, which
will be added to your trade ticket. Do you want to buy these bonds?"

The price he quoted, $74, really means the cost of each bond is $740. The convention
when quoting bonds is to drop off the last zero, so $740 becomes $74.

Investor: "Yes. The total trade is $7,400 (10 bonds x $740 = $7,400) plus your
commission. Is that correct?"

Broker: "Yes, that is correct."

Investor: "Thanks. Have a good day."

II: Margin of Safety: Why Bond Investing Works So Well

Bonds legally oblige a company to pay you. The managers cannot get around this. The
company must pay you, or you can declare a default and put the company into bankruptcy.

No matter what happens to the company, every day you earn interest, and twice a year it must
pay you. As a bondholder, you stand first in line to be paid. Meeting interest obligations is
among the top financial priorities for virtually every company. And in the worst case,
bankruptcy, bondholders have one of the top claims on the liquidated assets of the company.
Again, you get paid first.

Our prior bond publication, True Income, recommended in April 2008 subscribers buy a bond
from the drugstore chain Rite Aid. It is a perfect example of the safety and security of investing
in bonds. This deeply discounted bond paid a yield of 10.7% and an annual return of 17.4% over
the next five years. These annual returns more than doubled the investment.

https://members.stansberryresearch.com/post/87199 Page 14 of 18
 2/14/17, 5:34 PM

Rite Aid is America's third-largest drugstore chain. It is in a growing, recession-resistant

industry – dispensing prescription drugs. The company easily and regularly generates enough
cash to pay you.

The assets of the company were valuable... So even in a distressed liquidation, the business
would generate enough cash to pay you completely. This bond offered complete safety and
security.

Carefully selected bonds give you high income, large capital gains, and perfect protection of
your capital.

III. A Downgrade Is a Bond Manager's Worst Nightmare

A downgrade is a reduction in the credit quality of a borrower. It says to the borrower, "You
just got worse," and tells the lender, "Your borrower may not be as able to pay you as before."

Credit-rating agencies, like Moody's and Standard & Poor's, issue credit ratings on borrowers.

They study and analyze a borrower and issue an opinion. That opinion, or rating, is in the form
of a letter grade, just like grades in school. An "A" is good, a "B" is not as good, a "C" is OK, and
a "D" is, well, bad. If the circumstances of the borrower change, the credit-rating agency issues
an "upgrade" in the case of improvement and a "downgrade" in the case of deterioration.

In addition to measuring credit quality, credit ratings are also used to price a loan. The higher
the credit rating is, the lower the cost, or interest rate, on the borrower's loan. The borrower's
interest cost, or coupon, is fixed for the life of the loan.

When credit ratings are issued, they apply to the length of the loan. If a borrower wants a 30-
year loan, the credit agency analyzes the prospects for the borrower for the next 30 years. The
best credit ratings, called "investment grade," for the longest time... like 30 years, are only
issued to the most powerful, stable, and financially strong borrowers.

Downgrades to credit are bad news for a company issuing the bond, and they can dramatically
reduce the market value of the bond. As bad as that is, a downgrade can be even worse news for
bond managers...

Bond managers work for institutions – like insurance companies and pension funds – that
invest in bonds. They oversee large pools of fixed-income assets. A typical portfolio might be

https://members.stansberryresearch.com/post/87199 Page 15 of 18
 2/14/17, 5:34 PM

several billion dollars or even several hundred billion dollars. PIMCO, the largest bond
manager in the world, has $1.47 trillion in assets under management, as of the end of 2016.

Because of the importance of financial strength to customers and pensioners, the law governs
the types of investments they can make. These organizations are limited to buying only
investment-grade bonds. This assures their policyholders or pensioners they will be paid.

When a bond is downgraded to less than investment grade, the portfolio manager must
immediately sell that bond. Since all the bond managers holding this bond must do the same
thing, it drives down the bond price and generally results in a capital loss for the manager.

This is often a bond manager's worst nightmare.

But to us, a downgrade is a beautiful thing. It means we can now buy a bond, after careful
analysis, at a big discount to its par value. This means a bond manager's capital loss is our
future capital gain.

A downgrade to high-yield status also means there is now limited chance of any future
downgrades. The downgrades, and the price declines that go with them, are over. In this sense,
the prices of our recommended bonds are more stable than the prices of many investment-
grade bonds.

IV. The Credit Ladder: How Credit Quality Affects Bond Coupons
As with any loan, when we buy a bond we must decide how much to charge (the interest rate)
and for how long (the maturity). The answers depend on the borrower's ability to repay us, or
its credit quality.

As you might imagine, the bond market has a structure to answer these questions. The
borrowers with the best credit pay the lowest interest rate. And the interest rate on a loan for
30 days is generally lower than the interest rate on a loan for 30 years.

The borrower with the very best credit rating is the U.S. government. It has never defaulted on
a loan, and a loan to the U.S. government is considered to have no risk. The U.S. Treasury
borrows at the lowest cost for every maturity date. All other borrowers pay more according to
the risk they represent.

The riskier the borrower is, the more interest the lender requires. It is much like a stepladder.

https://members.stansberryresearch.com/post/87199 Page 16 of 18
 2/14/17, 5:34 PM

Each step goes higher and represents a higher risk and higher interest rate. The floor where we
put the ladder is the zero-risk level, which is U.S. government debt.

The following stepladder chart shows the cost to borrow for all levels of credit quality.

At the bottom is the lowest-cost and lowest-risk borrower, the U.S. Treasury. Each step on the
ladder is a higher interest charged to a higher-risk borrower.

The first four steps are considered high grade, called "investment grade." That means these
loans have almost no chance of defaulting. The remaining three steps make up the high-yield
end of the debt market.

You will notice each step of the ladder is labeled with a letter or a combination of letters. These
ratings are like your school report card. They range from an "A," which is excellent, to a "C,"
which shows substantial default risks. In credit ratings, "double A" is better than an "A," and
"triple A" is the very best rating.

These letters are called credit ratings. The rating represents the risk assessment of the
borrower. This is done by a ratings agency. The three major agencies are Moody's, Standard &
Poor's, and Fitch Ratings. The borrowers pay for these ratings.

Next to the letters is an interest rate that goes with the letters. For example, the first step is a
credit rating of "triple A," which is excellent. A borrower with this credit rating can borrow for
10 years at a cost of 2.5%.

You will note the interest rates go up rapidly as we get into the high-yield area of the
stepladder. A "triple C"-rated borrower would pay 13% for a loan, roughly 10% more than the

https://members.stansberryresearch.com/post/87199 Page 17 of 18
 2/14/17, 5:34 PM

"A"-rated corporation has to pay.

The borrowers in the high-yield range have a much higher chance of not paying their debt, or
defaulting. However, the long-term record of defaults is very low. For example, out of hundreds
of issuers of high-yield debt, only 60 defaulted in 2014. Even during the global financial crisis,
there were only 268 defaults in 2009.

When a corporation wants to borrow money in the bond market, it pays one of the agencies for
a credit rating that determines the loan's price, or coupon.

New borrowers start on one step of the ladder but can move up and down the ladder over time.
A new borrower hopes to maintain and even improve its credit rating over time. This will lower
its cost to borrow in the future. The performance of new borrowers sometimes deteriorates,
and the credit agency downgrades the borrower's credit rating.

https://members.stansberryresearch.com/post/87199 Page 18 of 18