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Author: trader2012 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35362  
Subject: Estimating Market-implied Rating Date: 11/24/2012 12:43 PM
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Years ago, when GE was still rated triple-AAA, it was obvious to anyone who followed the bond-market professionally that GE wasn’t triple-AAA, because its yield was anomalously high. Subsequently, the rating-agencies did catch themselves up to the financial reality that GE had been cooking their books, and they did the downgrades they should have done years sooner. But the market “knew” GE was cooking its books, and through its pricing, it had been discounting that info years before. To which, there were two possible responses. In one case, the uninformed bought GE’s bonds and then congratulated themselves for buying seemingly high-quality debt that offered a better yield than its similarly rated peers. “Well, No.” The debt they were buying wasn’t triple-AAA. That’s why it offered the anomalous yield it did. In other words, those buyers were entirely oblivious to the risks they were taking on that -- this time -- they got away with.

In the other case, buyers bought GE’s debt with their eyes open. They knew GE wasn’t disclosing its financial problems and that those problems might put the company under. That wasn’t the most likely scenario. But it had to be assumed that bankruptcy was a genuine possibility, and subsequent disclosures revealed just how close GE came to failing due to the shenanigans of its financial arm. And it probably would have failed if the government hadn’t bailed them out by doing the hocus-pocus of declaring GE a “bank” and lending them TARP money. In other words, GE could have been Lehmans, and it could have suffered their fate. That second group of buyers of GE’s debt didn’t pay a lower price than the first group, nor did they get better yields. But they were more fully-informed buyers, and they probably paid more careful attention to their exposures to GE’s debt.

The fat lady still hasn’t sung. The events that began in 2007 still haven’t played themselves out fully. So, currently, those who went over-weight GE’s bonds are doing better than those who limited their exposure. But if/when the market turns down again, that story could easily change, and if that same scenario is run another 10,000 times, in quite of few of them GE will fail, just as other once tripled-AAA rated issuers have failed, and those who were over-weight will suffer the consequences. Again, the uniformed and the informed both pay the same price, and both receive the same yields. But the uninformed will eventually suffer financial losses from their obliviousness, if not blow up their account irrecoverably. That’s why paying attention to the discrepancies between market-implied rating and agencies-assigned rating matters. The existence of downside discrepancies is a “heads-up” warning that there are hidden risks to the bond that need to be managed. I.e., the bond is riskier than it appears to be from its rating alone. OTOH, upside discrepancies --wherein a bond is offering less yield than its similarly-rated peers-- are a clue that the bond might be safer than it appears to be.

Rating discrepancies and outliers can be problematic for bond investors. But, also, they offer opportunities. So let’s see if we can find some instances where the market implied-rating differs from the agency-assigned rating in the tranche that “defensive investors” would be trolling, which would be the AAAs, AAs, and As.

[…to be continued]
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