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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: Exploring Triple-AAA Corporates Date: 8/12/2006 3:26 PM
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The following is mostly notes to myself. Read them or ignore them as you choose. But the general problem I'm attempting to solve is fairly typical. I've got a bond coming due this week, and I need to put the money back to work. So I'm trying to decide what looks worth buying. The specific problem I'm dealing with is that the bond is held in my IB account. It's a tiny position, $5k, but IB pays no interest on cash balances less than $10k. So I attempt to carry no cash in the account. The chief purpose of the account is for it to be a trading account, not an investment account. So I carry bond positions against which I can borrow to do my stock or futures trading (which hasn't been much lately.) Obviously, if a junk bond opportunity is compelling and I can execute through IB rather than E*Trade, then I'll do so. But, generally, IB either doesn't quote, or can't get me a fill on, the spec-grade issues I'm looking at. So I'm forced to buy further up the credit spectrum than I normally go, and triple-AAA's are about as “up” as one can get. So that's where I started looking this morning, as I did my weekend preps for this coming week's markets.

Out of laziness (and the fact that E*Trade has bought out the competition), I tend to use E*Trade as my default search engine. To their credit, they are aggressive about providing inventory, and the search engine they provide for creating bond scans is quite adequate. Additionally, they make offering lists available 24/7. Obviously, the prices will be stale and unexecutable when markets are closed. But often enough, a bond that is found over the weekend will still be priced the same come Monday morning, or close enough. So the leisure of a weekend gives one time to look and think. One further feature I like about E*Trade's bond department is that the results of one's scans can be downloaded into Excel. So, with that background in mind, here is commentary on some of my morning's activity.

Triple-AAA bonds aren't shaded into finer discriminations with 1, 2, 3, or plus's and minuses. The issue is AAA, or it isn't (with rare exception), and few AAA's rated by S&P or Moody's aren't also rated by the other. So there isn't the problem of dealing with split ratings that one encounters further down the credit spectrum. Asking for only AAA's returned 437 issues spread across approximately 23 issuers. But the bulk of the offerings, approximately 87%, were due to one issuer or its clones, namely GE Capital. They dominate the AAA market, both in terms of product and highest yields.

An aside: Just because a bond can't be found in an offering list doesn't mean the bond doesn't exit. An offering list is simply that: a list of current inventory, and the inventory is constantly changing. Also, just because one of a company's bonds carries a certain rating doesn't mean that all of its issues will (due to seniority factors). Therefore, having found a bond to look at, the next step is to pull data on all of the company's bonds, both all their currently traded ones, plus a listing of their total issuance. The purpose of doing so is to look for patterns that might shed light on why the particular issue that caught your attention is priced as it is and, especially, to identify anomalies.

Curiously, very few AAA's were callable above par, though equally curiously, just over half were callable. Coupons ranged from zero (a mere 1.3% of the list) to a high of 9.25%. About 10% had coupons above 6% and were trading at premiums that ranged as high as 136.739. About 70% of the coupons fell between 4% and 6%. And dozens of other facts can be observed about this collection of bonds. The point of doing the comparing and observing is to develop a feel for the data, so that one gains a sense of what is customary and what is unusual.

Currently, 6 3/8% was the top yield for AAA's, but one had to go fairly long to get that. So the next process kicked in of deciding how far down the credit spectrum to go in order to shorten maturity, plus the work of establishing where the sweet spot of the yield curve for each rating might be might be and what, collectively, might be the best compromise between yield, maturity, credit quality, and “under-priced opportunity”. Describing the making of that decision would be tedious to write up and tedious to read, and naming my choice would be pointless, because it would be out of context, and most people who buy their own bonds --I'm guessing-- will use entirely different procedures. But the point of making this informal report is this: investment decisions are the result of research, and doing research is just a matter of asking questions and looking for answers.

Charlie
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