Searching for yield in all the wrong places

Wed Jul 16, 2014

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Whitebox's Andrew Redleaf reveals the rating agencies' gift to arbitrageurs.


   Andrew Redleaf of Whitebox Advisors
 

By Andrew Redleaf

Financial market arbitrage is an enduring business for a simple reason: business model efficiencies create financial market inefficiencies. Rational motives create (apparently) irrational prices. The impact of the rating agencies on bond markets is perhaps the outstanding example of why most financial market "mispricings"-and thus most arbitrage opportunities-are not the result of investor "mistakes." In the current low-yield, high-risk environment, inefficiencies spurred by the rational behavior of the ratings agencies create the potential for perspicacious fixed-income investors to modestly elevate returns without increasing risk.

The vast majority of investors invest in fixed income instruments because they want, well, fixed income. They want to know to what extent any given bond is just like money; to what extent could it be used in a transaction the same way money is used in a transaction-almost instantaneously, almost effortlessly, and with almost no need for supporting information or additional inquiry into its value.

The ratings agencies respond to this need by providing what is in essence a stamp (AAA, BB, C, etc.) that predicts that likelihood of future complications-the likelihood that additional time (negotiating the company through re-org), effort (negotiating the sale of the bond to a distressed specialist), and understanding (assessing recovery rates and future cash flows) will be necessary to convert the bond into cash. Because the ratings agencies and their customers are interested only in the likelihood of complications, not in the outcome of complications, the agencies estimate only the probability of default; they do not incorporate recovery prospects.

Is this some terrible mistake? Are the ratings agencies, on these grounds alone, incompetent? Not at all. The ratings agencies don't incorporate estimates of recovery because they tend to serve a clientele that does not apparently care about recovery: the 90+ percent of fixed income investors who don't ever, ever want to touch recovery with a 10-foot pole. Given this clientele, it makes sense to treat default risk as a threshold, and to create groups of bonds that can be treated all alike. A bond with a significant prospect of default, regardless of the prospects for recovery, cannot be said to be as money-like as one without such prospects.

This business-model efficiency creates inefficiencies within the bond market. Because the bond market is so vast, and the micro-neighborhoods within it so numerous, almost every rating change or warning makes some rules-based investor a forced seller. A bond whose rating has changed has thereby fallen out of his policy mandate. Over the life of a bond, the natural ownership base of which changes many times, a great deal of money gets left on the table via such policy sales. That money is a potential gift to arbitrageurs because we are not rule-bound. We thrive on complications; bonds in transition from one group of natural owners to another are our meat and drink.

In addition to creating inefficiencies by design, ratings agencies also make mistakes, both systemic and idiosyncratic. One systemic error we've observed over the years is the tendency to underweight the importance of the ratio of equity market cap to total debt. Consider the apparently identical bonds of two companies. Both firms have total debt of $500 million; similar business profiles and prospects; identical coverage ratios. One firm, however, has a market cap of $500 million and the other a market cap of $1.5 billion. The apparently identical bonds of these firms represent significantly different risks. Should the $1.5 billion market cap firm need to pay down debt, it can raise $150 million from an equity issuance with only a 10% dilution to shareholders. For the $500 million firm, the dilution would be three times as great. To be sure, any future pathway that might compel either company to raise cash to satisfy creditors would be a complicated one implying other radical changes not contemplated in ceteris paribus. Still we'd rather start with the three-to-one advantage.

By contrast, we think the agencies tend to systemically overweight "obsolete history," recent but now irrelevant events. The best example is re-organization itself. A firm goes into re-org with twice as much debt as it can service, a bum management team, and unsustainable labor agreements. It comes out the other end with debt reduced by two-thirds, bright shiny new managers, and labor agreements that are the envy of its peers. Assuming the business model is sound and the sector attractive, what's not to love? Yet often the ratings agencies seem to hold a grudge for years, rating the bonds of the re-organized firm lower than those of firms with similar profiles.

It also seems to us that the agencies are insufficiently interested in business risk, or optionality. Agencies are interested in business risk, yes, but they focus on the past (balance sheets) and present (coverage ratios). They appear to be less interested in determinants of the company's future, perhaps leading them to give their stamp of approval to a company with 100 years of profitable practice behind it whose only flaw is that it happens to have made all its profits in a business on the verge of extinction.

We believe this lack of forward thinking is the rating agencies' biggest mistake. They are quite sure their job is to judge the present by the past, current obligations against the past accumulation of assets or past performance of the firm. The future they are all too willing to leave to equity investors, AKA speculators. But the business prospects of a firm are the future history of its capital structure. As a business prospers, even without any explicit adjustments, the capital structure grows more secure on a growing equity base. If the business degenerates badly enough, bond-holders may find to their dismay that their securities look more like equity every day.

This orientation toward the past played a major role in the great failure of the ratings agencies during the mortgage crisis. In fact, the mortgage crisis was a perfect storm, a confluence of all the major weaknesses of the ratings agencies. By trying to give subprime loans the same stamp of approval they gave traditional loans, they failed to properly assess not just the likelihood of default, but the likelihood that default would result in a huge loss for investors. Rating mortgage backed securities by the metrics of the past, they may have failed to see that because of changes in mortgage structure (essentially the emergence of low down payment adjustable instruments) the most powerful factor in future default rates would be future housing prices, a circumstance previously unknown in U.S. history.

Given the well-publicized failures of 2005-2008, we've been curious to see whether the markets' views of the rating agencies had changed. To be blunt, did the crisis shake the markets' faith in the rating agencies?

How would we determine this? Our hypothesis was that if in the wake of the crisis bond investors put less credence in agency ratings, then we should see the relationship between bond ratings and yields become more scattered, and less clustered. This would suggest more investors making up their own minds, more tendency to price bonds based on the investors' own analyses, or some other indicators, rather than the ratings.

A surge of independent thinking by bond investors might even be bad for the arbitrage business. If bond prices became less likely to cluster around bond ratings and instead were driven by more exacting measures of value, a fairly obvious source of inefficiencies and mispricings would potentially be diminished.

For four different years-2002, 2006, 2010, and 2014-we studied U.S. corporate bonds maturing in seven to 10 years with ratings of B, BB, and BBB. We settled on these ratings for two primary reasons:

First, bonds with CCC or lower ratings are widely understood to have sufficient default risk such that it seems reasonable many or most investors engaged with such bonds would rely less on the ratings agencies and more on their own analysis. Also most bonds in the C neighborhoods are of little interest to most fixed-income investors.

Second, given current yields it is more valuable to yield-hungry investors to find a B- or BB-rated, slightly higher yielding bond that actually has A quality characteristics than to find an A-rated bond with AAA characteristics, since virtually all A-rated bonds have depressingly Treasury-like yields.

For each year, the graphs are charted by number of bonds with a given yield: that is, the amount of bonds of a particular rating at each effective yield percentage. The more impact ratings agencies should have, the more bonds of a particular rating should cluster around different yields. The less impact, the more scattershot the graphs should appear.

We started in 2002:In 2002 we see the peaks we'd associate with bond rating clusters, with BBBs peaking between 6-7%, BBs between 7.5-8.25% and Bs between 8-9%. But there's a lot of noise in this graph as well, in part because the sheer number of BBB bonds is far greater than that of B or BB bonds. While there is certainly a discernible relationship between effective yields and bond ratings, it is somewhat muddied by the distribution of bonds between 8-10% effective yields.

By 2006, that muddiness is for the most part gone, with bonds rated BBB, BB, and B each having their own clear peak pretty much where we'd expect. Note that the peak yield for each rating has come in slightly, and instances of outlier BBB bonds have vanished. This year was the start of the mortgage crisis. Between 2006 and our next data set, the American financial system experienced a once-in-a-generation shock, in part triggered we believe by the mistakes of these ratings agencies. If doubt were to creep into the market's mind regarding the reliability of Moody's, S&P etc., surely we'd see it here.

Instead, we see the opposite. BBB-rated bond yields now cluster between 4-6%, BB-rated bonds between 6.5-8%, and B-rated bonds with a wider curve but generally peaking between 8-10%. The spread between BBB- and B-rated bonds is larger than at any other point we graphed.

By 2014, not only had yields downshifted, the spreads between ratings had compressed. B-rated bonds now peak between 5-6%, where BBBs were just four years prior. Meanwhile BBBs cluster around the paltry yield of 3.5-4%. But even with the compressed distribution, the impact of the ratings agencies seems evident to us: BBB bond yields in 2014 are clustered more tightly than BB bond yields which are tighter than B bond yields, a relationship that was also true in 2010, 2006, and 2002, despite the persistent systemic and idiosyncratic inefficiencies that permeate the market. In other words, the more a bond rating makes a bond acceptable to the mainstream investor, e.g. BBB v. B, the more tightly valuations cluster around the rating. This suggests that for the mainstream fixed income investors, the rating agency stamp of approval is still a powerful indicator of value.

Investors targeted on gaining modest yields/risk advantages in the current sparse environment may wish to consider exploiting this tendency of bond prices/yields to over-conform to agency ratings. Look for bonds that bear a B-ish rating with commensurate yields but may deserve to be rated a notch or two higher after considering the factors we detail above. With three-year Treasuries priced to yield well under 1.0%, picking up even 50-100 basis points by assembling a portfolio of moderately under-rated bonds could be well worth the effort.

Andrew Redleaf is the founder and CEO of Whitebox Advisors.

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ISSN: 2151-1845 / CDC10004H