Inside today’s Daily Journal…

Editor’s note: Porter has turned the Journal over to Marty Fridson, lead analyst for Porter & Co.’s Distressed Investing. For nine consecutive years, Marty was ranked No. 1 in high-yield strategy. He has written seven books, the most recent of which is The Little Book Of Picking Top Stocks… and Marty is such a legend that there is a recently published book about corporate finance that devotes an entire chapter to him. We excerpted last year in the Daily Journal.

Here’s Marty…

Great news!…

For the first time ever, Porter & Co.’s analysts are united in their expectation of a violent reversal in stock prices that could wipe out decades of responsible savings and investments.

After you recover from your double take, consider this fuller statement: “That’s great news for distressed-debt buyers!” The best opportunities to build wealth in these securities come about precisely when investors totally capitulate.

According to conventional investing wisdom, “Bonds serve as a foundational component of an investment portfolio primarily to provide stability, income, and diversification.” That doesn’t describe the bonds that my Distressed Investing team has recommended during the past few years of positive growth in the economy and volatile but upward-trending equity prices. They’ve behaved more like growth stocks, with some returning over 40% by the time we recommended selling them.

During severe downturns, many of these bonds act like meme stocks – in a good way. Let’s see what that means.

The accompanying chart shows one-year total returns on some of the most deeply depressed corporate bonds as of March 9, 2009. That was the low point for such securities during the Great Recession. (The S&P 500 bottomed out three days earlier.)

The group’s top performer – Michaels Stores 13% maturing 11/1/2016 – was priced at $40 on a $1,000 face value… that’s four cents on the dollar. (In the standard bond-market notation used in the table, that appears as 4, with par value denoted as 100.) Over the next 12 months, the price shot up all the way to $830 (or 83 in bond-market lingo). Taking into account the income received during the period (based on an incredible beginning current yield of 13 ÷ 4 = 325%), as well as reinvestment income, the Michaels Stores bond delivered an almost unfathomable 2,134% total return.

Three other bonds in the group returned more than 1,000% as the debt market recovered. The returns of all 10 bonds exceeded 400%. And this wasn’t the result of a turnaround by one particular sector of the economy. These huge winners were spread across a wide range of industries.

How can bond prices ever descend to levels low enough so that they can rise high enough to produce such stratospheric returns? After all, bonds rank ahead of stocks in distribution of remaining company asset value in the event of a bankruptcy. That’s supposed to protect holders on the downside.

A clue to this conundrum lies in the fact that the prices of some of the bonds shown above rose five-fold to 20-fold despite being downgraded by the credit rating agencies. The capital gains didn’t arise primarily from fundamental improvements in the companies’ balance sheets or operations. Neither did these issues rally for the reason that bonds as a group ordinarily rise on a given day, namely a drop in interest rates. After all, when yields go down, bond prices go up, The Wall Street Journal regularly reminds its readers. The benchmark 10-year U.S. Treasury rate increased from 2.89% on March 9, 2009, to 3.70% on March 10, 2010.

No, the astronomical price rises you see in the chart resulted from a subsiding of the all-out panic that characterized the credit market at its low point during the Great Recession. In early 2009, capital had fled the corporate debt market on a massive scale. Under normal conditions, fund managers would have jumped in if they saw a bond dropping even a couple of points below a reasonable estimate of its fundamental value.

But now they weren’t looking for that kind of opportunity to grind out an edge of a few basis points over their benchmarks. They were solely concerned with damage control, hoping to avoid a crushing blow to their performance so severe that their future marketing efforts would never be able to overcome it.

With no other bidders on the scene, distressed-debt buyers saw a feast prepared before them. This was the sort of environment they dream about through all the lean years in between recessions and financial crises.

Let me hasten to add that even though the debt market was far less discriminating than usual in 2008-2009, it was certainly not the case that you could have bought any distressed bond at random and made out like a bandit. Many of the extremely low-priced bonds of that period defaulted, even though none of the ones in the chart did.