The recent credit crisis has forced many companies to default on their loans or declare bankruptcy. Rating agencies are even talking about downgrading the rating on U.S. Treasury bonds from AAA. Bond investors are worried; is any company safe? But, where there is chaos, there is a chance to make money. The fear of default has pushed the price of many bonds lower than it should be. At first, it appears that only big investors, like hedge funds will profit from this mispricing. Really, small investors too can give their portfolios a boost by investing in bad loans with a long-term viewpoint.
What makes a bad loan?
Bad loans can happen for a variety of reasons. The company who took out the loan could be on the verge of filing bankruptcy. A homebuyer could be close to losing a mortgage or a town could be heading towards default. Of course, as the investor in bad loans, you don’t want any of these things to happen. The key is to look for “bad” loans that only appear bad on the outside. This disguise is where smart investors make their money.
Finding Bad Loans
Bad loans increase when the economic outlook of a country turns uncertain. People begin to fear various calamities, which have only a small chance of occurring. Then, when one of the calamities, also known as a black swan, happens, people panic. The price of any financial asset, including bonds, falls out of whack. The astute investor should look for under priced bonds issued by different companies. Corporate bonds are the easiest for small investors to invest in, as mortgage bonds are mainly traded between Wall Street banks.
Picking the Right Bond
There is no one way to pick the right “bad loan” to invest in. If there was, the bonds wouldn’t be cheap and underpriced. Wall Street banks and other major investment firms use complicated formulas and computer programs which take in over fifty variables to figure out what they should buy. The average investor usually doesn’t have the knowledge to calculate with all of this information. What he or she can do is analyze a few basic facts about a company:
1. Debt load of the company-Too much debt makes it harder for the company to pay off.
2. Revenue strength-A company making strong revenue during an economic recession is a plus for the business.
3. Relative Strength of Competitors-If a company is performing better than other companies in its sector, the company’s bonds are probably underpriced.
4. Icon status-If the company is an American icon, like Coca-Cola or Wal-Mart, and isn’t facing specific problems, the company’s bonds are probably a good buy. Use caution, though; buying Ford right now, although an American icon, is a risky proposition.
5. Market Predictions-If the economy is poised to reverse and go on an uptrend, bonds become a safer buy.
Remember Risk
In the end, all an investor in “bad” loans really does is judges risk better than others. He or she analyzes a bond, decided if the price is low enough, and makes the deal. If you, as a small investor, can do this, you will end up on top.