A fortnight or six ago, I told you kids about the passive income source which are junk bonds. Skip the next paragraph if you’re already well aware of said asset class. If not, prepare to get your face educated RIGHT OFF.
Junk bonds are debt instruments issued by companies that are down on their luck. Individually, they’re pretty risky, but can also lead to some pretty exciting profits when you get the trade right. They’re much safer as a group, so I usually suggest y’all buy a junk bond ETF or a closed end fund.
I own the Dreyfus High Yield Strategies Fund (NYSE:DHF) because it uses leverage to really goose the yield from its portfolio of junk debt. It currently pays a dividend of 9.6%.
One thing I didn’t focus on when talking about junk bonds before was the ideal time to buy. If you’re buying the asset class as an income play, you shouldn’t really care about underlying price movements. As long as you’re happy with the yield, just let the price flap around like the Simpsons watching Japanese cartoons.
That was short-sighted. It always matters what you pay for an asset. Getting yield is nice. Getting a sweet capital gain along with an outsized yield is even nicer. It’s like an extra scoop of ice cream. Nobody says no.
It turns out there’s a really easy way to predict the return of junk bonds going forward. Seriously, it’s uncanny.
Junk bond return indicator
Here’s how it works. Junk bonds will always trade at a premium yield versus other bonds, because they’re riskier. Duh, right?
You’d also think this premium would remain relatively steady over time, with junk bond yields rising and falling with interest rates. This happens a lot of the time, but there are also issues that only impact the junk bond market individually.
One example today is the energy sector. A lot of energy bonds have entered junk status because oil remains under $50 per barrel. If the price of oil falls, the entire junk bond sector can get hit.
Junk bonds also will rise or fall depending on the general economic outlook. Even though the asset class tends to perform pretty well as a group, when the economy suffers, investors run away, convinced every junk bond is going to go to zero.
Like with any investment, the key to buying junk bonds successfully is to get in when they trade at a huge premium to safer bonds and get out when the gap narrows.
The St. Louis branch of the Federal Reserve keeps track of the spread. Let’s take a look at the last 10 years worth of numbers.
We’re obviously not going to see 2009 numbers anytime soon, but let’s focus on late-2011 and early-2016. Both times, the spread between safe bonds and junk debt peaked at about 9%. It was a good time to get in.
Looking at a long-term chart of NYSE:JNK, the largest junk bond ETF, confirms it.
If you would have bought in October, 2011, and sold in 2014, you’d be looking at a capital gain of at least 10%. Plus the nice yield. The capital gain had you bought in early 2016 would have been similar.
You’ll notice that while today probably isn’t a good time to buy junk bonds, the spread in 2007 was even lower. You can see what happened next. It works as a contrarian indicator as well.
Yes, it really is that simple
Sometimes, investing can be easy.
To ensure capital gains when buying junk bonds, buy when the spread approaches 10%. It worked in 2011 and 2016, and even would have worked out well in 2008, assuming you didn’t panic and sell when the spread went over 20%.
With the spread being so low today, I’d recommend against buying. Getting a decent yield is nice. Getting a decent yield with upside is better. Remember, capital gains matter too.
Everyone, meet my new friend Jerry. He’s a true millionaire next door.
Jerry is a long-time Financial Uproar lurker who I recently met on a trip to Calgary. Like me, he’s accomplished a lot without actually going to university. Jerry started out working as a grunt on construction sites before being offered a job as a plumber’s apprentice. Four years later he had his journeyman status and was making a good wage.
He worked for the same company for a decade before the old owner decided to retire. Unable to find a buyer, he simply shut down the company. Seizing the opportunity, Jerry immediately hired three of his most useful co-workers and started his own plumbing company, knowing he already had a bunch of potential customers. That was in 1998, which was pretty much the best time to start a plumbing company in Calgary.
Nearly 20 years later, Jerry’s plumbing outfit has a half dozen employees and regularly earns Jerry between $100,000 and $150,000 a year. He has a net worth of $2.5 million despite his wife not working for the last 25 years and two kids who “eat too damn much.”
Jerry truly is a millionaire next door, so naturally I had questions. Lots of questions. Fortunately, Jerry was comfortable answering, as long as I didn’t reveal anything too sensitive.
Here are some of Jerry’s best financial tips.
Buy a house
OH SNAP WE’RE GETTING ALL CONTROVERSIAL IN HERE ALREADY.
Jerry is a huge fan of owning your own home. Even in today’s overpriced real estate market.
“I understand it’s cheaper to rent today, especially in my neck of the woods” he says, “but when I sign up for a mortgage I know the cost of ownership is going to stay relatively close to the same. Just be smart when buying and you can handle a rate hike.”
Besides, Jerry loves his home for another reason. It gave him an asset to borrow against when he started his plumbing business. He reckons his $50,000 in startup capital is worth at least $250,000 today.
Conservatively value your net worth
Jerry has an interesting way of calculating his net worth. He excludes his house and his business, even though they’re worth about $750,000 combined. Why?
His business is an easy one. He says he basically “bought himself a job” by starting his own company, although he admittedly doesn’t work very hard. He’s the flex employee. If there’s too much work for his existing team, then he goes and helps. He says he’ll be grateful if the business sells for anything when he decides to hang up his wrenches.
As for his house, Jerry figures he needs a place to live anyway. He’ll book the value on his net worth once his high school-aged kids move out for good and he sells. The plan is to downsize to a condo or townhouse partly so “my kids don’t decide to move back in.”
Speaking of Jerry’s kids, he has no interest in them making their own way through school. Both have $50,000 waiting for them upon graduation from high school, but with one caveat. They must go to university (or trade school) in Calgary to get it.
The reasoning is simple. “We have world-class schools right here. It makes no sense to leave the city to ‘find yourself’ or other such bullshit. Find yourself on your own dime.”
Jerry also plans to give each of his kids an additional $50,000 when they buy their first home.
I asked Jerry about this parental welfare, and his explanation was simple. He agreed it could lead to a troublesome case where his kids become useless, but he would much rather help them out at the beginning of their career when they could use the money. “It makes no sense to hoard all of my money to my kids when they’re 50 and already well-established.”
Jerry’s portfolio is almost exclusively invested in dividend-paying stocks.
Jerry’s first experience investing wasn’t a good one. I’ll let him tell you the story.
I was 19 or 20 years old with a buddy with a brother who worked for some obscure mining company. I ran into the brother one night at the bar and he told me there was so much gold in this company’s mine they were practically tripping over it. So I immediately threw most of my meager life savings into the stock, which naturally started falling. After losing 80% in a few months I couldn’t take it and cashed out.
Jerry started investing in mutual funds, but decided he’d rather invest himself. He stuck to blue-chip stocks that paid a dividend. He owns between 40 and 50 stocks today, mostly in Canada. Most of his net worth is in stocks. Top holdings include National Bank, Fairfax Financial, Extendicare (partly on my recommendation), and Telus.
Gerry’s goal was always to create an income stream in retirement. He was especially delighted to know the tax bill on these dividends will be virtually nothing.
But Nelson… these tips aren’t that exciting
Perhaps the biggest thing I took away from my conversation with Jerry is there’s no magic bullet needed to become a millionaire next door. He just plugged away at life, made smart decisions, and patiently waited for his net worth to head higher.
As much fun as it is to ask guys like Jerry their secrets, ultimately we already know a lot of them. There’s no secret sauce to becoming a millionaire next door. We all already know the steps. It’s all about execution and staying motivated.
I’ve received so much good financial advice I barely know where to begin. I’m much more sure of the worst financial advice I ever received, however.
The year was 2008, and I was a struggling Realtor/mortgage broker. When I got into the business, I decided I was going to wear both hats as a value proposition to my customers. I’d use mortgage marketing to get them in the door, pre-qualify them, and then go show them houses in their price range.
It was a fine theory that didn’t quite work out, for a couple of reasons.
First, I was a really terrible marketer. To be successful at something like that, you need to spend thousands of dollars per month in marketing to bring in a steady stream of interested folks. I was barely spending $100 a month on a crummy little ad in the newspaper, which generated about four phone calls a year.
Second, people would only phone me when they had exhausted their options with their bank. Sometimes I’d be able to help them (usually by taking the mortgage myself), but most of the time these people had no money and a terrible credit score. I was just wasting my time even talking to them.
Related: living life with a terrible credit score is easier than you think
I was having a little more success actually selling houses, but not a whole lot. I went from working at a grocery store to selling real estate, and the first year I made about 75% of what I made at the store. That wasn’t really what I had in mind, but it wasn’t a bad result. It takes time to get established in the business.
This wasn’t fast enough for my broker, however, which lead to all sorts of innovative motivational techniques.
The worst financial advice ever
One night he took me out for dinner to try and teach me how to drum up more business.
He suggested a number of ideas to get my name out there, including walking around to every business in the downtown core to introduce myself and hand out candy canes, since it was close to Christman. He also recommended I spend an hour each day walking around and ringing doorbells in nice neighborhoods.
I would have none of this. The last thing I wanted was to, and I quote “act like a used car salesman.” I viewed a lot of that kind of stuff as despicable. Talking to randoms all day long was (and still is) my own personal version of hell.
Looking back on it, it’s easy to see why I was a terrible salesperson. I like talking to you guys through a screen. I would hate doing it on a person-to-person basis all day, every day. When I type, I can proofread and change stuff I don’t like. It’s hard to take back misspoken words.
In his haste to help me — and to help himself, since he got a portion of my commissions — my broker suggested the worst financial advice I’ve ever gotten. He said my problem was I had low expenses, and therefore had no motivation. If I created a bunch of new expenses, I’d have no choice but to hustle to meet my obligations.
His main suggestion? Replace my perfectly reasonable used car with a brand new, bigger vehicle, that came with a substantial car payment. Yes, this was said with a straight face.
It’s been a decade since I received that advice, and it still makes my head hurt. It is, by far, the worst financial advice I’ve ever received.
Minimize expenses, don’t create them
Us here at Financial Uproar (me and 46 pet rats) are big fans of maximizing our incomes. It’s the whole reason why I advocate investing in everything from trailer parks to blogs.
But in order to have capital to invest in these things, you have to create a huge savings rate. Earning more is a big part of that equation, but it also helps to minimize expenses. Do both and you’re laughing.
That’s exactly what I intended back in 2008. I took steps to spend as little as possible so I could focus on investing the biggest percentage of my income as possible. The only problem was the income didn’t come. Primarily because I was terrible at my job.
The solution to this wasn’t to add more expenses. Are you kidding me? The solution was something I figured out a couple of years later, when I became a potato chip salesman. I needed to find something I was good at.
I can think of very few personal finance problems that can be solved with increasing expenses.
What is the worst financial advice you’ve ever received? Comment away, yo.
The Snap Inc. (NYSE:SNAP) IPO happened last week, giving millennials yet another reason to prove to older generations that they will forever doom our planet to a premature death, probably from explosion. They delivered, snatching up shares with all the gusto of me buying up North Korean currency.
What? You gotta admit that country only has one direction to go. Nukes!
The issue was supposed to debut at $17 per share, but strong interest before the open shot shares up to $24 before the first trade was made official. It went all the way up to $29.24 during trading the next day before falling faster than my chances to make friends with the rest of the PF blog-o-net. Shares trade hands for $22.71 as a write this, a major bummer for anyone who bought during those first couple of days.
Snap’s IPO wasn’t the only one to go nuts over the first little while and then fall below their issue price. The Facebook IPO popped during the first few hours of trading before retreating quickly.
Twitter exploded higher after its late-2013 IPO. By May, 2014, it was trading under the issue price.
LendingClub soared after its December, 2014, IPO. Just over two years later shares are down 78%.
Not every big IPO has been a disaster, of course. Long-term investors who bought Facebook during its first day of trading don’t regret the decision. The Alibaba IPO went relatively well, too. And Shopify is up about a million percent since its 2015 IPO. That math is 100% right. No reason to check it.
Still, buying the latest IPO is a pretty bad idea. Here’s why.
The logistics of IPOs
Basically, an IPO works like this. A company decides it wants to go public, usually for one (or more) of the following reasons:
- Prestige of trading on a major stock exchange
- The chance for employees to cash out stock
- Pressure from investment bankers looking to make a buck
- Easier to raise money in the future
- Valuation gap between public and private investment money (i.e. retail investors giving it a richer valuation because they’re suckers)
A company wishing to go public will contact several investment bankers and ask them to draw up some sort of plan. They’ll discuss logistics like the size of the deal, the potential offer price, and so on.
Once the company picks one or two underwriters to work with, it’ll start discussing the real details of the deal. Say a company wants to raise $100 million, consisting of 10 million shares at $10 each. The underwriters will then ask for a bonus allotment, which they’ll exercise if the deal goes well.
The company then gets to work on its prospectus, which is a long and boring document investors are supposed to read before they plunk money down. Spoiler alert: they never do. The prospectus is half sales copy and half risk factors, and is designed to give investors an idea of what they’re buying. It’s a lot like an annual report.
Up next is the road show, where the underwriters and company management go and sell the deal to potential investors. It’s usually only big investors who are invited to such a thing. The road show will last 10 days or so, and hit every major market. Depending on the size of the deal, they might even make a stop in Europe or Asia. OOOH EXOTIC.
After speaking to investors on the road show, the underwriters decide where to price the deal. Say demand for my imaginary IPO is strong. They’ll come back and recommend a price of $11 or $12 per share. The opposite happens if demand is weak. Remember, the underwriters want to under price the IPO so it pops on its first day of trading.
Finally, the big day comes. Demand usually outweighs supply, so it takes the stock exchange anywhere from a few minutes to over an hour to start matching up buy and sell orders. If the stock is up, the underwriter will exercise their bonus allotment. If the stock is up, usually everyone is pretty happy.
What happens after the IPO?
Study after study have looked at IPOs a year or two after they debut on the stock market, and they all say pretty much the same thing. On average, IPOs underperform. You’d be better off to buy a boring ol’ index.
The reason for this is pretty simple if you think aboot it. When the underwriter does their job, they’re creating a huge demand for shares. The IPO usually represents peak demand.
A few months after the IPO, the same investment banker will often quietly arrange a secondary offering, which usually allows more insiders the chance to cash out. This will also help push the share price down.
Investors who get a piece of an IPO aren’t stupid, either. They usually only hold for a few hours, flipping their shares to some other sucker amid the frenzied first day. If the IPO is hot, CNBC or BNN will cover the hell out of it. This attracts retail investors. The cycle completes itself a few months later when they get bored and sell.
The Snap IPO is the perfect example. It’s more overvalued than popcorn at the movies. Eventually the people buying shares will sit down and realize that.
The bottom line? Just avoid IPOs. At a minimum, give any new shares six months before taking a look, just to let the dust settle.
Ever since Donald Trump SHOCKED THE WORLD and upset Hillary Clinton on that Tuesday night in November, approximately 53,923,109,477.627 man hours have been dedicated to the issue that will impact all of us, greatly:
Where in the hell are my keys? Seriously, guys, I’ve looked everywhere.
(3 hours later)
They were in my pocket.
The financial media (including this guy), have been consumed with telling you kids how to invest in a Donald Trump world. We focused on things like infrastructure spending, an improved market for coal, and oil, TransCanada finally getting Keystone XL approved, and so on. Basically we just looked at Trump’s campaign promises and made educated guesses.
That’s the hard-hitting journalism you kids are getting these days. I saw the stats, and people ate that ish up. It was amazing.
Most of the advice was pretty predictable. You should do absolutely nothing, it said, because Donald Trump is just a small part of a big machine that mostly functions the same no matter which jabroni runs it. He’s not going to screw it up so badly, in other words.
Or you could have followed this guy’s advice.
I will cry real tears if this ever gets deleted. What a tweet.
There are still millions of people out there who are convinced Trump is going to get us all killed, even though it’s been months since the election. There’s nothing you can say to convince these people, either. They are still 100% invested in the Trump is an evil, dumb, giant crook theory. Cruise Eichenwald’s Twitter feed if you don’t believe me.
If you’re one of those people, may I suggest putting your money where your mouth is?
An actual bet on Trump
Buying a U.S.-based index fund is, at best, an indirect way to bet on Trump. No matter how much he tries to meddle, there are various checks and balances in place.
Besides, the American economy is strong. It’s going to take more than Donald Trump to squash it. It’ll take at least two Donald Trumps. Maybe even three.
There’s an actual way to bet on (or against) Trump, which is to place an actual bet with a bookie. Here are the updated odds:
Let me translate the odds for those of you who don’t speak gamblor:
- A $1 bet on Trump to not be reelected in 2020 would pay $1.50
- A $1 bet on Trump to be impeached or resign before the end of his first term would pay $1.25
- $1 bet on Trump to serve his entire first term would pay out $2
- $1 bet on Trump to visit Russia would pay $2.50
- And a $1 bet on Trump to win the Nobel Peace Prize would pay $26 to the winner
Let’s think about those odds for a second. You’re getting far more value by betting Trump will serve his whole term (100% potential payout) versus betting he’ll impeached or resign in disgrace (25% payout).
Keep in mind that there’s only been one president that has ever resigned in disgrace. Most politicians find a way to make it through their entire term, even the really bad ones. Hell, if Trump is as evil as everyone says he is, he’ll find a way to make himself dictator and you win.
Thinking about investing as betting
It’s no coincidence many good investors are also good at gambling. Warren Buffett was big into horse racing. Ed Thorp conquered blackjack before moving onto managing money. And so on. There are plenty of other examples.
Value investing is essentially the search for asymmetric odds. If you invest $1 in something that goes to zero 50% of the time and increases to $3 50% of the time, the implied value of that investment is $1.50, or a 50% return. That’s a good investment, provided you’ve got more than one opportunity to make it.
In other words, not all of your portfolio should be in things that could legitimately go to zero. And those bets should be spread out.
There’s also sentiment to think about. Bookies are saying bets against Trump are coming in about five times faster than bets on him. A gambling house doesn’t want that kind of action. It wants equal betting on both sides. It doesn’t care about the odds of something happening.
Both professional gamblers and professional investors have that in common. Both are taking advantage of asymmetric odds. They just have different ways of doing it.
This is the end
The Trump odds are clearly weighted towards the less likely thing happening. Identify those situations as a value investor and you’re already well on your way to making money.
Oh, and I’m curious to know. Which side of the Trump bet would y’all take? Let me know in the comments (without getting too political, please!).