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Kamakura Blog

Feb 24

Written by: Donald van Deventer
2/24/2014 12:30 AM 

On February 21, 2014, the bonds of Google Inc. (GOOG) were the 18th most heavily traded of any reference name in the U.S. fixed rate corporate bond market.  Another iconic name in technology, Apple Inc. (AAPL), ranked 21st. We reviewed Apple Inc. in this series of notes on January 20, 2014. This is a rare opportunity to make a bond market comparison between the two names, which normally don’t trade in such volume.

Google, for example, did not make its bond market debut until May, 2011. Google issued 3.375% notes due in 10 years last week, which is what has triggered higher trading volume in its bonds. A total of 105 trades were reported on February 21 on 4 fixed-rate non-call senior bond issues of Google Inc. with trading volume of $61.6 million. Of that volume, $52.4 million of trading volume was in the new 10 year Google bonds. For Apple Inc. there were 157 trades on 4 bond issues with an underlying trading volume of $55.6 million. We used all of that data in this note.

Conclusion: Google Inc. default risk is at or near the lowest levels in the USA software and services peer group. Google Inc. bonds offer a credit spread to default probability ratio that is slightly below the median for all bonds which traded at least $5 million on February 21. Investors paid a small premium for the scarcity value of Google Inc. bonds.  For those investors who want a better reward to risk ratio and a similar iconic name, Apple Inc. bonds offer better value.

The Analysis

Institutional investors around the world are required to prove to their audit committees, senior management, and regulators that their investments are in fact “investment grade.” For many investors, “investment grade” is an internal definition; for many banks and insurance companies, “investment grade” is also defined by regulators. We consider whether or not a reasonable U.S. bank investor would judge Google Inc. to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010.  The default probabilities used are described in detail in the daily default probability analysis posted by Kamakura Corporation. The full text of the Dodd-Frank legislation as it concerns the definition of “investment grade” is summarized at the end of our analysis of Citigroup (C) bonds published December 9, 2013.

Assuming the recovery rate in the event of default would be the same on all bond issues of the same issuer, a sophisticated investor who has moved beyond legacy ratings seeks to maximize revenue per basis point of default risk from each incremental investment, subject to risk limits on macro-factor exposure on a fully default-adjusted basis. In this note, we also analyze the maturities where the credit spread/default probability ratio is highest for Google Inc.

Term Structure of Default Probabilities

Maximizing the ratio of credit spread to matched-maturity default probabilities requires that default probabilities be available at a wide range of maturities. The graph below shows the current default probabilities for Google Inc. (in green) ranging from one month to 10 years on an annualized basis. For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. As a benchmark, we also show the annualized default probabilities for Apple Inc. in yellow. The Google default probabilities range from 0.00% at one month (0.000473% before rounding) to 0.00% at 1 year (0.0004% before rounding) and 0.09% at ten years. 

We also explain the source and methodology for the default probabilities below. 

Summary of Recent Bond Trading Activity

The National Association of Securities Dealers launched the TRACE (Trade Reporting and Compliance Engine) in July 2002 in order to increase price transparency in the U.S. corporate debt market. The system captures information on secondary market transactions in publicly traded securities (investment grade, high yield and convertible corporate debt) representing all over-the-counter market activity in these bonds. We used the 4 bond issues mentioned above in this analysis.

The graph below shows 6 different yield “curves” that are relevant to a risk and return analysis of Google Inc. bonds. These curves reflect the noise in the TRACE data, as some of the trades are small odd-lot trades. The lowest curve, in dark blue, is the yield to maturity on U.S. Treasury bonds (TLT)(TBT), interpolated from the Federal Reserve H15 statistical release for that day, which exactly matches the maturity of the traded bonds of Google Inc.. The next curve, in the lighter blue, shows the yields that would prevail if investors shared the default probability views outlined above, assumed that recovery in the event of default would be zero, and demanded no liquidity premium above and beyond the default-adjusted risk-free yield.  The orange dots graph the lowest yields reported by TRACE on that day on Google Inc. bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day.  The red dots show the maximum yield in each Google Inc. issue recorded by TRACE. The black dots and connecting black line show the yield consistent with the best fitting trade-weighted credit spread explained below.  Note that the black dots completely obscure the green dots in the case of Google Inc.

The graph shows an increasing “liquidity premium” as maturity lengthens for the bonds of Google Inc. This is a pattern seen usually with firms of good credit quality.  We explore this premium in detail below.

The high, low and average credit spreads at each maturity are graphed below for Google Inc. We have done nothing to smooth the data reported by TRACE, which includes both large lot and small lot bond trades. For the reader’s convenience, we fitted a cubic polynomial (in black) that explains the trade-weighted average spread as a trade-weighted function of years to maturity. The polynomial explains 100% of the variation in credit spreads over the maturity spectrum because there were only 4 traded bonds.

In the next graph, we compare the Google Inc. trade-weighted average credit spreads (in green) with the traded credit spreads on Apple Inc. (in red, of course) bonds on the same day, February 21. Except for the shortest maturity Apple Inc. bond, credit spreads for Google Inc. were far narrower than the credit spreads for Apple Inc.

Using default probabilities in addition to credit spreads, we can analyze the number of basis points of credit spread per basis point of default risk at each maturity. In the following table, we show these results on February 21 for both Google Inc. and Apple Inc.  For Google Inc., the credit spread to default probability ratio generally ranges from 6.9 times (on the new 10 year bond) to 22.6 times on the bonds due May 19, 2016. By comparison, the credit spread to default ratios for Apple Inc. range from 10 to 12 times. The ratios of spread to default probability for all traded bond issues for both companies are shown here:

The credit spread to default probability ratios are shown in graphic form below for Google Inc. The very short maturity bond, which is being refinanced by the new ten year issue, has a very high credit spread to default probability ratio:

For better visibility, we plot the same ratios for both Google Inc. and Apple Inc., omitting the shortest maturity Google Inc. bond.

The graph makes it clear that the two longest maturity Google Inc. bonds are trading at a reward to risk ratio well below the Apple Inc. bonds. Are these reward to risk ratios “normal”? Are they above or below average?  The best way to answer that question is to compare them to the credit spread to default probability ratios for all fixed rate non-call senior debt issues with trading volume of more than $5 million and a maturity of at least one year on February 21.  The distribution of the 386 traded bonds that met these criteria on February 21 is plotted in this histogram:

The median credit spread was 1.03% and the average credit spread was 1.30%.

The next graph plots the credit spread to default probability ratio for Google Inc. (dark blue) versus the other issuers with more than $5 million in trading volume on February 21.  The line connects the median credit spread to default probability ratio for all issues.

The line varies because the issuers traded at each maturity point are different.  Nonetheless, the dark blue dots representing the Google Inc. credit spread to default probability ratios (with the exception of the very short maturity bond) are either at or slightly above the median at every point on the maturity spectrum.

The graph, however, obscures some critical information. 168 out of the 386 large trades on February 21 had better credit spread to default probability ratios than the best ratio for any of the Google Inc. bonds which traded at least $5 million in volume. The median spread to default probability ratio for all 386 trades was 10.56. Here are the 20 “best trades” done February 21, 2014 that had the highest ratios of credit spread to default probability.  We have also reproduced the credit spread to default probability ratios for bond trades over $5 million in volume for both Google Inc. and Apple Inc.  The highest ranking Apple Inc. bonds both ranked higher (at 131st and 147th) than the highest ranking Google Inc. bonds.

Credit Default Swap Analysis

The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name.  No credit default swaps on Google Inc. or Apple Inc. have traded since the DTCC started reporting weekly in July 2010.

Additional Analysis

On a cumulative basis, the default probabilities for Google Inc. (in green) range from 0.00% at 1 year (after rounding) to 0.92% at 10 years. The cumulative default risk for Apple Inc. (in yellow) is very close to that of Google Inc.

Over the last decade, the 1 year and 5 year annualized default probabilities for Google Inc. have remained at a low level that many of the largest financial institutions in the world would envy. The 1 year default probability (in blue) peaked at about 0.02% in 2009.  Apple Inc. 1 year default probabilities (in yellow) were near 0.06% in 2004.
The 5 year annualized default probabilities for Google, Inc. (in blue) were near 0.10% in 2004-2005. The 5 year default probabilities for Apple, Inc. (in yellow) were as high as 0.24% in 2005.

As explained earlier in this note, the firm’s default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors.  Over a long period of time, macro-economic factors drive the financial ratios and equity market inputs as well. If we link macro factors to the fitted default probabilities over time, we can derive the net impact of macro factors on the firm, including both their direct impact through the default probability formula and their indirect impact via changes in financial ratios and equity market inputs. The net impact of macro-economic factors driving the historical movements in the default probabilities of Google Inc. have been derived using historical data since the company’s initial public offering.  A key assumption of such analysis, like any econometric time series study, is that the business risks of the firm being studied are relatively unchanged during this period. With that caveat, the historical analysis shows that Google Inc. default risk responds to changes in 4 risk factors among the 28 world-wide macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 83.0% of the variation in the default probability of Google Inc. The remaining variation is the estimated idiosyncratic credit risk of the firm.  A similar relationship for Apple Inc. explains 70.5% of the variation in Apple Inc. default risk.

Google Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat.  For the USA “software and services” sector, Google Inc. has the following percentile ranking for its default probabilities among its 462 peers at these maturities:

1 month 2nd percentile
1 year 0 percentile (second lowest)
3 years 0 percentile (lowest)
5 years 0 percentile (3rd lowest)
10 years 1st percentile (4th lowest)

Google has exceptionally strong peer rankings. Taking still another view, the actual and statistically predicted Google Inc. credit ratings both show a rating strongly in the “investment grade” territory.  The statistically predicted rating is 4 notches below the legacy rating, those of Moody’s (MCO) and Standard & Poor’s (MHFI).  The legacy credit ratings of Google Inc. have changed once since 2010.


Because of Google’s exceptionally low default risk, we dispense with our usual comparisons with sector peers and investment grade peers.

We believe that an exceptionally strong majority of sophisticated analysts would rank Google Inc. as an investment grade company.  The long run default probability outlook is at or near the best of its peer group, and its default probabilities have varied in a very narrow band since the company’s initial public offering. 

We remind readers that a below average default probability is not sufficient reason to buy a bond.  The bond must offer “good value,” which we define in terms of the ratio of credit spread to the matching maturity default probability.  By this measure, Google Inc. bonds offer a credit spread to default probability ratio that is slightly below the median for all bonds which traded at least $5 million on February 21. While this may not be an endorsement that excites some investors, it is a far better reward to risk ratio than many of the iconic brand names that have been reviewed in this series to date. Investors paid a small premium for the scarcity value of Google Inc. bonds.  For those investors who want a better reward to risk ratio and a similar iconic name, Apple Inc. bonds offer better value.

Author’s Note

Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firm in question. We believe that other authors on SeekingAlpha, Yahoo, at The New York Times, The Financial Times, and the Wall Street Journal do a fine job of this.  Our omission of those headlines is intentional.  Similarly, to argue that a specific news event is more important than all other news events in the outlook for the firm is something we again believe is inappropriate for this author.  Our focus is on current bond prices, credit spreads, and default probabilities, key statistics that we feel are critical for both fixed income and equity investors.