Transponder/Encoder troubleshooting

Hey all. Any avionics advice for troubleshooting my latest
gremlin? It's a Narco AR-850 altitude encoder connected vi 1N4007 diodes
to a KT-76 transponder and (no diodes) to a KLX-135A VFR GPS/COM. Trouble
is, once in awhile the ModeC doesn't work (center says only
ModeA). Every once in awhile, they report back an incorrect altitude.
Most of the time, however, it works fine.

I figured the encoder was crapping out, but the GPS reports the
correct altitude, even when center says it's off. I thought initially
that the diodes were causing too much voltage drop and corrupting the data
to the transponder.

Trouble with that theory is that if the diodes were too much drop,
then a bit in the grey code would be a '1' instead of being a '0' (i.e.
the encoder not pulling the line down low enough). When I checked the
error, however, the bits were flipped in the wrong direction. For
example, after a climb from 7500' (0x642 grey code) to 9500' (0x672
grey code), the center reported 7500'. The only way this could
happen (that I can think of) is that the grey code lines are negative
assert (i.e. '1'=0v, '0'=5v).

Any thoughts? I'm kinda at a loss here, since I can't isolate any
one issue, and I certainly don't want to start replacing components that
aren't broken!

Thanks in advance,
-Cory

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