A question was asked of me in another forum of how it was possible to have a 26.9% YTM on a bond. Here is the simple answer. “Buy the bond cheaply, and then hope it doesn’t default.” Seriously, that’s the essence of high-yield bond investing. So let me do some basic review.
Whether you call them ‘bills’, ‘notes’, ‘bonds’, ‘debentures’, CDs, whatever, they all (generally) share these characteristics: an interest rate (which might be fixed, floating, or implied, as in the case of zero-coupon bonds) and a maturity date (though there are perpetual bonds). Generally, par is $1k, though some bond-like things trade in factions of that.
Bonds are generally priced as a percentage of par. Thus, Transocean’s 6.8s of '38 are currently priced at 96 and change --meaning it costs $968.76 plus a commission to buy one bond–, which is a price that creates a YTM of around 7%. But if that bond is bought at one-quarter of that price, as I did six years ago, then the YTM bumps up proportionally, because the coupon payout is based on par, not the purchase-price.
Thus, if a couponed bond with a relatively nearby maturity can be bought at a steep discount to par, two things happen. A high current-yield is created, and a high yield to maturity is obtained. How many of these high-yield opportunities currently exist? Precious few. But 25 years ago, there were plenty of solid, double-BB’s that offered 12% to 15%. This brings me to my second point, defaults.
The 5-year historical default rates for all bonds, top-tier to bottom tier, triple AAA to triple CCC, can be looked up. Very few top-tier bonds default. They generally are just downgraded. Lots of lower-tier bonds do default, and is that part of the reason they are called ‘junk bonds’. But if across a basket of securities, be they stocks, bonds, whatever, the payouts and the defaults can be estimated and managed, then buying junk stocks or junk bonds isn’t a math game any more difficult to understand than the odds of flipping pennies, which is a zero-sum game.
If the odds and payouts of a betting game are asymmetrical, as it often is with stock investing or bond investing, then it’s easy to buy in a disciplined manner such that winners more than make up for losers, even with some very adverse losses to wins ratios.
In other words, if something truly stupid isn’t done, such as betting the farm on a single issue or on just a few, then one’s inevitable losses can be tolerated. Thus, investing survival and investing profitability are far more a matter of sizing one’s positions properly relative to one’s account size than a matter of getting the fundamentals correct. (The killer combo, of course, is to a decent job of both.)
My position in Transocean’s debt is small, and I never play the woulda/coulda/shoulda game of wishing I had bought more. That is the sure path to ruin.