In the fixed income and equity markets, securities often deviate in price from what the underlying ratings or analyst opinions would suggest should be happening. While it's more difficult to definitively state that certain financial metrics and analyst ratings should lead to certain multiples and prices in the equity markets, things are a bit different in the fixed income markets. With respect to fixed income, rating agencies (Moody's (NYSE:MCO), S&P, Fitch, etc.) attempt to assess the probability of an entity failing to meet its obligations under an indenture/offering memorandum. After an assessment is complete, a rating is assigned. The rating is supposed to be a forward-looking opinion about credit risk. It represents the credit rating agency's opinion of the credit risk of an issuer; in other words, it represents an opinion of the willingness and ability of an issuer to fully meet its obligations in the future.
Since credit ratings are supposed to represent an opinion about credit risk, fixed income investors can use credit ratings and current market prices to make comparisons between companies, even across sectors, and determine whether the market believes current ratings are wrong. If an investor is able to determine that the market believes current ratings are incorrect, this opens up investment opportunities for that investor. By finding anomalies in prices relative to credit ratings, similar to the one I outline below, an investor could use his or her opinion of whether the market is correct or whether the rating agency is correct to purchase or sell a bond at attractive prices (the aforementioned opportunity).
Coca-Cola's senior unsecured note (CUSIP: 191216AV2) maturing 9/1/2021 has a coupon of 3.30% and last traded at 107.55 cents on the dollar (2.415% yield-to-maturity before commissions). It has a make whole call and pays interest semi-annually. Moody's currently rates the note Aa3; S&P rates it A+. It was originally offered at a price of 99.913, and the offer size was $1,324,430,000. The offer date was August 10, 2011. Currently, the 8/15/2021 U.S. Treasury note (CUSIP: 912828RC6) is yielding 1.817%, which means Coca-Cola's note is trading 59.80 basis points higher than a corresponding Treasury note.
Berkshire Hathaway's (NYSE:BRK.A) senior unsecured note (CUSIP: 084670BC1) maturing 8/15/2021 has a coupon of 3.75% and last traded at 106.404 cents on the dollar (2.976% yield-to-maturity before commissions). It is non-callable and pays interest semi-annually. Moody's currently rates the note Aa2; S&P rates it AA+. It was originally offered at a price of 99.992, and the offer size was $500 million. The offer date was August 10, 2011. Currently, the 8/15/2021 U.S. Treasury note (CUSIP: 912828RC6) is yielding 1.817%, which means Berkshire's note is trading 115.90 basis points higher than a corresponding Treasury note.
Berkshire Hathaway and its Aa2/AA+ rating sits one notch above Coca-Cola on Moody's rating scale and three notches above KO on S&P's scale. However, despite having higher credit ratings, Berkshire's note maturing 8/15/2021 is yielding 56.10 basis points more than KO's note maturing 9/1/2021. Also, Berkshire's note matures a couple weeks earlier than Coca-Cola's, its coupon is higher, it is non-callable (versus KO's callable note), and it is more liquid than KO's note. If anything, these factors should give Berkshire's debt a further advantage. For some reason, the market is telling us it believes the rating agencies are wrong to assign Berkshire a lower probability of default than Coca-Cola. KO, with its lower rating, and less favorable bond terms (as noted above), should theoretically have a higher yield than Berkshire, assuming the rating agencies are correct in their assessment. This is where an investment opportunity presents itself for investors.
If you believe the probability of default is virtually zero for both issuers, or if you believe the market is wrong to push Coca-Cola's yield so low relative to Berkshire, why wouldn't you go for the higher-yielding of the two? Or, if you currently own the Coca-Cola note and believe the market has pushed its price far too high for its rating, you might consider selling it and purchasing a higher-yielding note with a similar or higher credit rating (Berkshire's, for example).
So who do you think will ultimately be correct: The market or the credit rating agencies? One way to further investigate this is to seek out other corporate notes with similar profiles as the two mentioned above. The purpose of doing this would be to see if the market is pricing other Aa2/AA+ notes and other Aa3/A+ notes the way it is currently pricing Berkshire Hathaway's and Coca-Cola's.
Questions to consider are the following: Is Berkshire's higher yield unique among other Aa2/AA+ issues? Is it unique among other companies involved in similar businesses? Is Coca-Cola's lower yield unique among other Aa3/A+ issues, and is it unique among other companies involved in similar businesses? While an investor would want to look at numerous examples before drawing any conclusions, for the purpose of this article, here are a few examples to get you started:
PepsiCo's (NYSE:PEP) senior unsecured note (CUSIP: 713448BW7) maturing 8/25/2021 has a coupon of 3.00% and is asking 104.635 cents on the dollar (2.455% yield-to-maturity before commissions). It has a make whole call and pays interest semi-annually. Moody's currently rates the note Aa3; S&P rates it A-.
Google's (NASDAQ:GOOG) senior unsecured note (CUSIP: 38259PAB8) maturing 5/19/2021 has a coupon of 3.625% and is asking 111.761 cents on the dollar (2.222% yield-to-maturity before commissions). It has a make whole call and pays interest semi-annually. Moody's currently rates the note Aa2; S&P rates it AA-. While it is true that this note matures roughly three months before the BRK and KO notes, ask yourself whether you think three months closer to maturity is worth 70 basis points on the yield curve (comparing to Berkshire's note).
JPMorgan Chase's (NYSE:JPM) senior unsecured note (CUSIP: 46625HHZ6) maturing 5/10/2021 has a coupon of 4.625% and is asking 101.389 cents on the dollar (4.44% yield-to-maturity before commissions). It is non-callable and pays interest semi-annually. Moody's currently rates the note Aa3; S&P rates it A.
General Electric Capital Corp.'s (NYSE:GE) senior unsecured note (CUSIP: 36962G5J9) maturing 10/17/2021 has a coupon of 4.65% and is asking 103.633 cents on the dollar (4.191% yield-to-maturity before commissions). It is non-callable and pays interest semi-annually. Moody's currently rates the note Aa2; S&P rates it AA+.
After briefly looking through corporate notes of similar ratings and maturity profiles, it appears that Berkshire Hathaway is being sandwiched between issuers with significant financial sector exposure (JPM, GE, etc.) and non-financial related issuers (KO, PEP, GOOG, etc.). Perhaps this is because of certain investments Warren Buffett has made in the financial sector.
Quite frankly, as a fixed income investor, I would be a bit concerned about a company making a $5 billion investment in another company with a balance sheet as complex and opaque as Bank of America's, especially when Buffett's idea for the investment was supposedly conceived just one day prior while he was in the bathtub. From my perspective, simply the haste with which the investment was made could justify a higher spread to Treasuries on Berkshire notes than other similarly rated corporates.
Additional disclosure: I am long CUSIP 38259PAB8 (GOOG).