No. of Recommendations: 2
Warning: This post is a rant. Don’t read it if you “can’t handle the truth”. LOL.

Ben --and you know whom I mean by ‘Ben’-- works with three intellectual categories: ‘Defensive’, ‘Enterprising’, ‘Speculative’. Doing some typological magic produces the following 5x5 array.
Typically Typically
Bonds Stocks

Purely Mostly Mostly Purely
Ord-Inc Ord-Inc Equal Mix Cap-Gains Cap-Gains

Defensive AAA & Better
Enterprising BBB-BB
Speculative CC & Worse

The color coding is gratuitous, but fun. So let’s keep it.

In other thread, a question was asked about the attractiveness of Greek bonds and their current 9%-10% yield. For sound reasons, I said “Pass”. But let’s review that decision. Assuming those bonds were available at the retails level --and they aren’t--, how should a would-be buyer be looking at them? In other words, forget about what someone else’s opinion might be. Could you, on your own, determine the attractiveness of those bonds? Probably not. So let’s try to build a framework within which any bond could be rated. Let’s do so by grabbing a triple AAA issue -- which the totally naïve would assume is a ‘Defensive’ investment -- and show that it isn’t by Ben’s own criteria.

Xto Energy’s 6.75’s of ’37 are rated Aaa/AAA. So there’s no question it’s considered to be ‘top-tier’ debt by the rating agencies. It’s priced at 151.754 to yield 4.4% to maturity. So there’s also no question that is top-tier by its market-implied rating. But I can predict, with nearly 100% certainty, that bond will default, and the workout will be $0.42 on the dollar. That doesn’t sound very ‘defensive’, does it? In fact, that bond must be considered ‘speculative’, for this reason. If today (May 9, 2013) you have $15,175.40 in cash, then you have $15,175.40 of purchasing-power. But if you do something as egregiously stupid as buy ten of Xto’s 6.75 of ’37, you can be almost guaranteed to end up with a loss of (57.8%) on that purchase, due to the impact of taxes and inflation. In what sense is choosing to lose money making an investment? In fact, it cannot be considered an ‘investment ’. It is a highly speculative bet that that taxes won’t rise, that inflation won’t rise, that interest-rates won’t rise, that the issuer won’t default, etc. It short, you’re betting on a ‘best-case’ scenario that is already a pretty horrible one. If you get any part of that forecast wrong, you’re screwed even worse than you already are. That bond might not ‘default’ in the technical sense of that term. But the impact of those losses on your net–worth won’t be any different.

By contrast, let’s grab a different bond and one that the naïve would consider to be ‘risky’. First, let me cheat with the example, and then I’ll work a real-time one. Where was Travelport’s debt trading last year, and into which ‘risk bin’ above did it seem to fall? Orange, right? Three tranches were on the market, some very nearby, low coupon, more senior stuff priced near par, and some junior, high coupon, deeply discounted stuff. All of it was clearly rated ‘speculative’ by the agencies and priced so by the market. But how ‘risky’ was it really? Under a worst case scenario -- a Chapter 11 filing that resulted in a zero workout -- you knew exactly what your losses would be, the premium you paid for that option. OTOH, you also knew what one of your upsides would be, i.e., the strike. What you didn’t know was the gain you could make from selling ‘time-premium’ (which is currently running about 187%).

In the game involved triple-CCC bonds, how often can you be wrong and still make decent money? In the former game involving triple-AAA bonds, how often do you have to be right to ensure that you don’t lose money? This is exactly why agency ratings and market-implied rating are only a starting point. Both of those numbers have to be put into context, and that context has to be understood before one can say ‘yea or ‘nay’ to the buying (or avoiding). In other words, as Ben himself says, “If you overpay, you’ve turned what might have been an ‘Defensive” investment into a speculative one. OTOH, if you can buy at the right price, what would otherwise be a very speculative bet become a very defensive, very high-quality investment."

Of the currently-offered, spec-grade bets, what might be worth looking it? Here’s a chart worth considering. But you’re on your own about what to do about it.

Standard Disclaimers: Due your own due-diligence, and I’m already long at better prices.
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