UnThreaded | Threaded | Whole Thread (1) | Ignore Thread Prev | Next
Author: trader2012 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Risk Outliers Date: 9/18/2012 2:57 PM
Post New | Post Reply | Reply Later | Create Poll Report this Post | Recommend it!
Recommendations: 3
I’ve written about the term ‘risk outlier’ before. But it needs re-doing in light of two things:

-the huge amount of late, dumb money that is flooding into bonds. (The linked article is but one of many. ) http://finance.yahoo.com/news/great-investing-dilemma-always...
-the accelerating rise in bonds prices, for whatever reason(s) that is happening.

Fidelity explains its proprietary term as follows:

Risk Test
To pass the risk test, a bond must be trading at a level that Fidelity believes is appropriate for its risk rating as defined by its yield curve. Bonds that do not pass the test are labeled Risk Outlier (RO). Bonds that pass the test are labeled Risk Pass (RP).
In addition, all bond with credit ratings of Moody's Baa3 or lower, or S&P BBB- or lower will not pass the test and be labeled Risk Outlier (RO).
For Corporate bonds:
The Option Adjusted Spread (OAS) and Option Adjusted Duration (OAD) is calculated for each bond.
Each bond is then compared to a series of Option Adjusted Curves that are created based on a larger universe of securities. For these bonds if the OAS is greater than the average OAS of bonds of lower credit quality with a similar OAD, the bond is considered a risk outlier. (For corporate bonds the classification of AA and AAA has been combined into a single rating: AA/AAA).
For example: if a AA bond is trading at an OAS greater than the 'average' OAS of an A bond (for the same OAD) this is considered a risk outlier. Likewise for an A bond that trades at a higher OAS than the average BBB bond.


No doubt, as you grind through their explanation, you’ll lose interest in trying to figure out what Fido is saying, so here’s the gist of it. If they slap an ‘RO’ label on an invest-grade bond, the credit-rating rating is probably bogus.

OK, keep that thought in mind, and consider another. Wikipedia does a really good job of explaining what credit-ratings are, and it offers an colorful, informative chart that compares the notation systems used by the three majors. http://en.wikipedia.org/wiki/Bond_credit_rating If you count the number of notches, you’ll see they add to 21, which is way too many to be practical. One way to cut those 21 down to more manageable size is to map them onto Ben Graham’s three-fold scheme, as below.
 
Long-term Long-term
Moody's S&P

1 Prime Aaa AAA Cash-equivalent

2 Aa1 AA+
3 High grade Aa2 AA Defensive
4 Aa3 AA-

5 A1 A+
6 Medium grade A2 A
7 A3 A-

8 Baa1 BBB+
9 Low grade Baa2 BBB Enterprising
10 Baa3 BBB-

11 Ba1 BB+
12 Speculative Ba2 BB
13 Ba3 BB-

14 B1 B+
15 Highly speculative B2 B Speculative
16 B3 B-

17 Extremely speculative Caa1 CCC+
18 Caa2 CCC

19 Default imminent with little Caa3 CCC- Lottery Tickets
20 prospect for recovery Ca CC

21 In default C D

I happen to know that, currently, ‘cash-equivalents’ aren’t worth looking at unless your intentions are to lose money. But I got to wondering whether investors new to the bond market could find anything worth buying in the “Defensive” category. So I ran the following scan at E*Trade. Show me everything rated A3/A- and above that offers at least 6%. Five issues were returned, three of which split-rated as triple-BBBs. The other two were Assured’s 7’s of ’34 and Sg’s 6’s of ’32. In other words, no more than two issues showed up of the thousand or so that would show up in the Defensive category if a minimum-yield weren’t established. In yet further words, it’s obvious these two have an anomalously high yield. Curious to see how Fido was quoting them, I pulled the info on Assured, on which it had slapped a RO label. Bingo! Suspicions confirmed.

To buy Assured Gty US Hldgs Inc’s 7’s of ’34 isn’t to buy an investment-grade bond, no matter how it is currently rated, nor is it to make a 'defensive' purchase. There's a speculative element embedded in that bond, or it wouldn't be priced as it is. Digging into the issuer's numbers might turn up the reasons. But doing so isn't something a 'defensive' investor would be doing. That's a task for an 'enterprising' one, which is the next category down in terms of effort and risk and, therefore, possible reward. In other words, each bond game has its own rules. To stray beyond one's self-set boundaries is just going to get you into trouble. (Graham's words, not mine.)

I’ll leave it to you to run a similar test for the other bond that showed up in the scan and for any bonds that might show up in each of the other categories. And if running these exercise seems to be a lot of work, well, tough sh*t. There's no such thing in the investing world as easy money, though, admittedly, once one's searching and vetting procedures have been refined and practiced, the gig does become no more intellectually demanding than brushing and flossing one's teeth. It's getting to that stage of fluid application where most investors (in fast food America) fail. They're unwilling to do the grind, grind, grind that is needed to pull money out of the securities casinos.

Charlie
--------------------
PS Sorry for the messed up table. If its details really interest you, scrape Wiki's page, dump it into Excel, and then do the reformatting there.
Post New | Post Reply | Reply Later | Create Poll Report this Post | Recommend it!
Print the post  
UnThreaded | Threaded | Whole Thread (1) | Ignore Thread Prev | Next

Announcements

Foolanthropy 2014!
By working with young, first-time moms, Nurse-Family Partnership is able to truly change lives – for generations to come.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Post of the Day:
Macro Economics

The Story Behind the Story
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
Community Home
Speak Your Mind, Start Your Blog, Rate Your Stocks

Community Team Fools - who are those TMF's?
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and "#1 Media Company to Work For" (BusinessInsider 2011)! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.
Advertisement