As many of you may know, the asset allocation strategy that I use for my clients is to buy low-cost stock index funds for the equity portion and individual investment-grade bonds for fixed income. Many of my clients have General Electric (GE) bonds in their portfolios, so let’s review what’s been going on recently.

GE Bonds and the Markopolos Report

After the decline in GE's stock — due to a negative stock report by Harry Markopolos — I received a concerned email from a client about GE bonds. Interestingly, the GE bond prices didn't change that much, even though the stock was down more than 14%. The main points in Markopolos’ report are related to the long-term care insurance business and their valuation of the Baker Hughes acquisition, which GE has already written down by $2.2 billion.

Markopolos claims that the market cap should be 40% lower. That’s still solvent, which is why the bonds aren’t down as much. He also works for a hedge fund that is shorting the stock. I’ve always considered issuing a negative stock report on a stock you have shorted to be price manipulation, but there’s a fine line whether it’s illegal when you disclose it upfront.

GE Bonds and Insurance Reserves

As it concerns the long-term care insurance, every company that wrote policies in the past thirty years has underestimated the payouts and didn’t price the premiums profitably. That is going to be an overhang for the company — and many others — for a long time, but it isn’t large enough to threaten its existence.

Markopolos claims that GE should add $18.5 billion to its insurance reserves to account for a shortfall in recognizing insurance liabilities. Insurance is highly regulated and reserves are probably the most important measure of solvency on the balance sheet. Even if Markopolos is right in the long run about the reserve requirement, the accounting in insurance would require GE to boost the reserve by reclassifying assets from surplus, not necessarily that it needs a full new cash infusion.

What This Means for Worried Bond Investors

Given the conflict of interest that Markopolos has readily disclosed, many aspects of his recommendations seem self-serving. As reported in the Wall Street Journal, even the former chair of FASB, Leslie Seidman — who is on GE’s board and knows something about accounting — said that his report had “creative” interpretations of accounting rules, as well as outright mistakes.

The stock price reflects the future expectations of investors. But the bonds reflect the strength of the balance sheet and cash flows to pay bondholders. Senior, secured bonds with a maturity less than four years still look sound. 

Contact me to learn more about the bond market or to schedule a consultation today.