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In an article about bonds, a subscription website (www.indexinvestor.com) presents the following information (without citing a source) on default rates. They say:

Through the end of 2002, cumulative default rates after ten years on differently rated instruments were as follows:

AAA, 0.48%
AA, 0.85%
A, 1.82%
BBB, 6.68%
BB, 20.82%
B, 35.87%
CCC, 57.21%

Let's create a Fibonacci series whereby any successor number (once the series is initiated) is the sum of its two predecessors, such as the following: 0,1,1,2,3,5,8,13,21,34,55,89,144, etc. The correspondences that obtain between bond default rates and the Fib series are striking, right? But there are also some discontinuities. Let's see if we can make them go away. That's the proposed experiment:

Can defaults by rating category be predicted from a Fib series?

Obligations of the US government aren't rated. They are asserted to be without default risk. (That's is more than a convenient fiction. It's a bald-faced lie. But let's play along with the Central Bankers.) So let's assign them a rating that reflects their preeminence. Will a quadruple, AAAA rating be sufficient? Treasuries really do stand head and shoulders above even the best of corporate debt. So, let's give them a quintuple, AAAAA rating, which has this benefit. If need be, “Agencies” can be separated out of AAA group and be given the unused, quadruple AAAA rating.

Next, let's consider the rating series listed above, AAA through CCC and ask a couple of questions:

What happened to CC, C, and D?

What happened to the pluses (+'s) and minus (–'s) that are typically used to provide finer degrees of discrimination (except for AAA's, which are never qualified)?

Now this is where the game gets interesting. We have partial information, but we want full information. So let's create it by doing some interpolation. Let's list the Fib series vertically and attempt to match up the known default rates.

0 AAAAA
1 AAA
1 AA
2 A
3
5
8 BBB
13
21 BB
34 B
55 CCC
89
144

Several things are immediately obvious. BBB's really do need to be split into their customary three groups: BBB+, BBB, and BBB-. The categories CC, C, and D need to be accommodated. Also, the problems of rating splits (whereby the same bond is given different ratings by different rating houses) and the problem of “implied market ratings” vs. “authorized ratings” both need to be dealt with. Plus, there are other niceties that can be done.

But let's assume that all of those problems are disposed of (as they must be if you're serious about buying your own individual bonds), and let's address another issue.

By convention, the ratings assigned to investment-grade debt are meant to reflect the likelihood that the payment of interest and principal will be timely. In other words, an effort is made to predict defaults. By convention, the ratings assigned to spec-grade debt also attempt to reflect an investor's recovery rate when default does occur. That is a crucial difference. As an investor, your concern should not solely be with a bond's default rate, but also must consider your potential recovery rate.

E.g., if you bought a couponed bond for 30 and you can estimate that your recovery rate is 40, you really don't care whether the bond defaults or not. Your money is protected and profitable. Yeah, you'd love to capture all of the upside but you're sitting in the cat bird's seat. But what if you bought at 80-85-90 and the company defaults and then offers its creditors 15-20 cents on the dollar? You're looking at a serious impairment of capital, which is why I hate the middle ground of the rating categories. I can't them cheap enough to manage the risks.

Genuine investment-grade bonds are priced high for good reasons. You're paying for insurance. Genuine speculative-grade bonds are priced low for good reasons. Their prospects of maturing are slender, and their likely recovery rate is lean. It is the middle ground, I would claim, where fair pricing is the hardest to determine and where the rewards for taken on risks are the most adversely disproportionate. That's not the conventional wisdom, but I've encountered junk bond pros who do agree.

The consequence of that anomaly (and negative inefficiency) for the
“average small investor” seems to be this: the middle ground is a tough area in which to compete and really is better left to the institutionals and better accessed through funds. OTOH, there is a persistent, positive inefficiency that attaches to junks bonds, and it seems to be capturable by a determined “small investor”. In other words, any individual who is a skilled, deep-value stock investor will have no extraordinary difficulties in doing the research needed to responsibly buy her or his own distressed debt. Whether she or he would want to do so is, of course, another matter.

But I would make this larger claim, that it is possible to think about nearly any investment problem in ways that the “crowd” or the conventional wisdoms are not doing and to see a path for yourself that you can make uniquely your own. And what I typically find is this. Once you do get your hands “dirty with data” and start asking questions, you create for yourself more possible investments and trades than you could exploit in a dozen lifetimes. So the problem becomes “Which paths to choose?” which ties back to who you are as a person, what your values are, and how you see the world. The money really is a very incidental part of investing. It's the game itself that matters.

Charlie

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