Thursday, March 12, 2009 0 comments ++[ CLICK TO COMMENT ]++

AAA bond species has been put on the endangered species list

Today, G.E. lost its AAA rating, at least from one rating agency, with others sure to follow. Standard & Poor's today downgraded GE from AAA to AA+. As Bloomberg reports, it was less than some bears were expecting--steeper cuts may have required G.E. to post collateral--but it still marks the end of an era:

General Electric Co. shares and bonds rallied after Standard & Poor’s lowered its debt ratings one level and raised the outlook to “stable,” comforting investors concerned about a possible sharper cut.

The switch to AA+, from AAA and with a “negative” outlook, affects long-term debt, S&P analysts said in a statement today.


General Electric had held S&P’s AAA since 1956, the year Immelt was born. The company has had Moody’s Aaa top rating since 1967. Today’s downgrade squares with what investors already see: GE has traded for six years as though its bonds were less than the highest rating.

G.E.'s downgrade probably marks the end of the AAA-rated bond market. There are only a few companies remaining and the size of the market will likely shrink. Accrued Interest has a nice pie chart illustrating how GE's bonds made up nearly all of the Merrill Lynch AAA Corporate Bond Index:

Berkshire Hathaway and Johnson & Johnson will be the two big constituents of the AAA market in the future. There have been rumours in the past that some company like Microsoft may start issuing bonds. I am not an expert but I believe Microsoft has never issued bonds, except for taking ownership of the Aquantative bonds after the buyout. Microsoft has no need for cash raised from bonds but if its stock performance doesn't improve, it is possible that shareholders will pressure the company to lever up (hence boosting returns for shareholders.) Barring the entry of companies like that, issuance of AAA-rated corporate bonds are going to be as rare as junk bond issuance* during the Great Depression ;)

It's amazing how far financial engineering has gone. I don't necessarily think it's a bad idea--it boosts shareholder returns--but it's still amazing. As The Economist alludes to, there were 60(!!!) AAA-rated companies in 1980 (at least according to S&P ratings):

Back in 1980 more than 60 American non-financial companies qualified for the ultra-chic AAA rating from Standard & Poor’s (S&P). Now there are just six.

That change is not just a reflection of the financial crisis or the recession. The decline in credit ratings has been remorseless over the past couple of decades. In 1987 just 38.1% of issuers in the American bond market were rated as speculative, or “junk”. In 2007 junk-bond issuers made up most of the market for the first time. The number of lowly-rated CCC issuers has almost tripled over the past 21 years.

Investors were willing to invest in anything and a full 50%+ of "new bond" buyers** felt satisfied investing in junk bonds in 2007. It should not be surprising to see low quality bonds being such a big part of the total bond market. After all, risk premiums were extremely low in the last 5 years (recall the numerous stories of excess liquidity a few years ago.)

I think it is almost a certainty that the trend mentioned in the quote will reverse soon. It is highly unlikely that the junk-bond market share will increase. Not only will investors be running scared from junk bonds due to their risk, the lockup in the credit market essentially means that you can invest in investment-grade corporate bonds at attractive yields. You can probably buy investment-grade corporate bonds at yields that surpass what the junk bonds paid you over the last 5 years. Not only that, professional bond investors are probably using leverage, which may be cheap (not sure about this,) to boost returns beyond what anyone would have thought possible in the last decade. (As a side note, raw yields, which is what small investors should be looking at since spreads are meaningless and we can't generally borrow large quantities safely, are still not very high. Depending on what you look at, yields are just above what they were in 2000. The exception is junk bonds, which have yields of around 20% and compare favourably to past yields.)

One of the implications of all this is that returns on equity may decline. I'm just guessing here and I'm not sure how much it matters. If equity returns were boosted due to increasing leverage in the last 20 years then it is only sensible to expect declining equity returns as leverage declines.

(* Junk bonds were not popular and did not really exist in their current form back during the Great Depression; Junk bonds only took off in the 80's. My understanding is that there were some low quality bonds during the 1930's but it was a small market. The closest to junk bonds would be defaulted railroad or utility bonds during that time.)

(** I'm sure there is better terminology but when I say "new bond", that's sort of like an IPO of a stock. Similar to stocks, the vast majority of transactions pertain to existing bonds so the "new bond" is only a small portion of the total market. Nevertheless, it's still remarkable that more than 50% of the "new bonds" were rated junk in 2007. A lot of these were obviously used for LBOs by private equity/hedge funds/etc.)


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