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A Nutty Rule Broken

I’ve talked about bond guys versus credit guys before. My Uncle Larry was totally a bond guy. The former tend to be more focused on the fundamental analysis and balance sheets. Credit guys are more focused on optionality and applying mathematical tools to finance. The ratings agencies, regardless of their supercomputers and number crunching are absolutely bond guys.

Bond guys by necessity categorize their lives less by objective mathematical rules and more by rules of thumb. Fair enough, because not everything in life is rigidly quantitative. But some of their rules are stupid, one of which is the subject of this post. The stupid rule in question: “A corporate bond can never have a higher rating than the sovereign in which it is domiciled.” In the case we discuss the rule became so glaringly stupid they had to break it.

Let’s back up. The creditor universe is huge and diverse. There are bonds with fixed coupons and bonds whose returns float. There are loans as opposed to bonds. There are securitized, or asset–backed bonds, that constitute returns from a bundle of aggregated securities. There are senior bond and subordinated bonds. They are hybrid bonds that operate in the shady area between debt and equity. I’m just scratching the surface here, but to organize and categorize such a wild and reckless creation of man investor must put them in buckets according to their credit risk. This bucketing process is the reason why credit rating agencies exist. The big three rating agencies may differ a little in how they evaluate a debenture, but the buckets are pretty much the same. See below.

In a rational world where governments have taxation authority to screw businesses as they need to in order to balance the books, it makes sense that a corporate bond will never have a higher credit rating than the sovereign government that has taxation authority over them. I suppose this rational world is conceived as having a large number of comparable corporate borrowers, and a government with complete ability to raise funds on a confiscatory basis to avert default. Further, this world is supported by liquid markets. This is not the rational world we live in.

In emerging market debt especially, there is absolutely no reason why a sovereign bond must always be assumed of higher quality than a corporate bond in that country. Imagine a bond maturing in 2020, priced with a mid-price of 82 and a yield of 13.4%. This company just retired a 2015 bond maturity without much trouble despite very trying circumstances. Very cheap, good income, management you can believe in. As to the prospects of this company, it is expanding capacity and growing poultry exports to the EU, giving it even more FX income to cover debt service. Its home currency, the hyrvnia, has seen an epic depreciation in 2015, which is a mixed blessing that makes at least a part of its cost structure cheaper. This company has seen preferential tax treatment in the past as an agricultural producer which is going to phase out, but the export orientation of the business makes it able to weather this storm.

So contrast this 2y7y off the run bond with the sovereign Ukrainian 2020 bond.

There is no way that even a staid, rule-based, play-it-so-safe organization like rating agency can game this rule into making sense. So they didn’t and reason triumphed over drudgery. Sort of. A bond yielding 13% is by no means priced like a CCC- candidate for default, especially given that MHP is absolutely in no danger of default because they just retired a 2015 bond with smooth sailing for five more years. Now bond guys and their methods are by no means dumb. My uncle Larry was one of the smartest men I ever knew.

Come on, that is the nutty part.

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