On March 18 in the U.S. bond market, there were 33,863 bond trades in 5,195 non-call fixed rate corporate bond issues representing $3,892,197,918 in notional principal. Which 20 trades were the best trades of the day, and how do we decide the answer to that question? Today, we answer those questions for bonds with maturities of 1 to 5 years at the request of many investors. This question is particularly important in light of the tight pricing on the rare $5.5 billion bond issue by Exxon Mobil (XOM) on the same day. We compare the Exxon Mobil deal to all other large trades in the market.
Conclusion: We find that 98 bond issues traded at better credit spread to default risk ratios than the Exxon Mobil deal. The best-value non-call senior fixed rate bond trades with maturities of 1 to 5 years on March 18, 2014 were issues by these firms:
- GOLDMAN SACHS GROUP INC. (GS), 6 issues
- AMERICAN EXPRESS CREDIT CORP. (AXP)
- TEVA PHARMACEUTICAL FINANCE II BV (TEVA)
- THERMO FISHER SCIENTIFIC INC. (TMO), 2 issues
- AON CORPORATION (AON)
- MARATHON PETROLEUM CORPORPORATION (MPC)
- ROYAL BANK OF CANADA (RY)
- CAMERON INTERNATIONAL CORPORATION (CAM)
- DISCOVERY COMMUNICATIONS LLC (DISCA)
- TORONTO DOMINION BANK (TD)
- INTERNATIONAL LEASE FINANCE CORPORATION (ILFC)
- NATIONAL AUSTRALIA BANK LTD. (NEW YORK BRANCH)(NABZY)
- HUSKY OIL LTD. (HUSKF)
- DOMINION RESOURCES INC. (D)
Best Value Long Maturity Bond Trades for March 18, 2014
In analyzing the best trades of the day, we used these criteria:
Bond type: Fixed rate
Seniority: Senior debt
Trade Volume: $5 million or more
Maturity: 1 to 5 years
We ignored legacy ratings in making today’s selection, but all but six of the trades meeting our criteria had an investment grade rating by the pre-Dodd Frank Act definition. We used the same criterion for “best” that we have used in recent analyses of bonds issued by Cisco Systems Inc., Google Inc.,Anheuser-Busch InBev S. A. (BUD),International Business Machines (IBM), Royal Dutch Shell PLC (RDS.A), Wal-Mart Stores Inc. (WMT), Apple Inc. (AAPL), Ford Motor Company (F), Sprint Communications Inc. (S), Verizon Communications Inc. (VZ), and General Electric Capital Corporation (GE). That criterion is the reward to risk ratio, calculated as the ratio of credit spread to matched-maturity default probability. The default probabilities used are described in detail in thedaily default probability analysis posted by Kamakura Corporation. Both the credit spreads and default probabilities are reported as percent figures. 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.
In all, there were 175 issues that met our criteria. The distribution of credit spreads is given in this histogram:
The median credit spread was 0.623%, and the average credit spread was 0.864%.
The distribution of the credit spread to default probability ratio is given in this histogram:
The median credit spread to default probability ratio was 11.77 and the average was 22.27. Note that the average is skewed by the very high credit spread to default probability ratios of the best credits. Note also that only ratios of 40 or below are plotted on the graph.
Here are the ranking results, listed from best to worst, with a Goldman Sachs Group Inc. bond issue the winner at a reward to risk ratio of 269 times. The new issue by Exxon Mobil ranked 99th at a spread to default probability ratio of 10.044:
Background on the Calculations
Assuming the recovery rate in the event of default would be the same on all bond issues, 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.
Maximizing the ratio of credit spread to matched-maturity default probabilities requires that default probabilities be available at a wide range of maturities. We used the default probabilities supplied by Kamakura Corporation’s KRIS default probability service, interpolated to a matched-maturity basis to the exact day of bond maturity. For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk.
Bond yields are secured from TRACE. The National Association of Securities Dealers launched the TRACE (Trade Reporting and Compliance Engine) system 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 trade-weighted average yield reported by TRACE for each of the bond issues analyzed. We calculated the credit spread using the matched-maturity yield on U.S. Treasury bonds, interpolated from the Federal Reserve H15 statistical release for the trade date. The source of the information on the H15 release is the U.S. Department of the Treasury.
Forward-Looking Best Value Bond Selection
Today’s analysis looks back at yesterday’s trades. A forward-looking bond selection based on today’s prices at this instant is done in the same way, with slight differences in the data sources.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firms 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.