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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Kamakura Blog

Apr 21

Written by: Donald van Deventer
4/21/2014 8:26 PM 

PepsiCo, Inc. (PEP) is an iconic name among U.S. consumer products companies. So far, in this series of notes, we have often seen the bonds of iconic names over-priced to such a degree that the reward to risk ratio for such names was far below average. Nonetheless, in today’s analysis, we make no assumptions about such things at this point. Instead, we let the bond market facts lead us to the appropriate conclusions. Today’s study incorporates PepsiCo, Inc. bond price data as of April 17, 2014 to get an institutional, bond market view of the company. We analyze the potential risk and return to bondholders of PepsiCo, Inc. using 87 trades on 15 bond issues and a trading volume of $41.9 million in today’s analysis. We also use bond market data to calculate the credit-adjusted dividend ratio for PepsiCo, Inc.

Conclusion: We believe a strong majority of analysts would rank PepsiCo, Inc. as “investment grade.” The bond market shows a credit spread to default probability ratio for PepsiCo, Inc. that is 6th among 175 bond trades of $5 million or more on April 17, 2014. While the ratios for PepsiCo, Inc. longer maturities were not as attractive, they offer much more value, as measured by the credit spread to default probability ratio, than other consumer products companies in the “icon” class of bond issuers.

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 PepsiCo, 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 PepsiCo, 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 PepsiCo, Inc. 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. The current annualized default probabilities range from 0.00% (after rounding to two decimal places) at one month to 0.00% at 1 year and 0.10% at ten years. Readers should note that no firm has a default probability of zero but the rounding to two digits sometimes obscures that fact.


Credit-Adjusted Dividend Yield
We explained in a recent post on General Electric Company (GE) how default probabilities and the associated credit spreads for a bond issuer can be used to calculate the credit-adjusted dividend yield on a stock . That analysis makes use of a comparison between the yield on the issuer’s promise to pay $1 in the future versus the yield on a similar promise by the U.S. government to pay $1 at the same time. Using the maximum smoothness approach to both the U.S. Treasury curve and to PepsiCo, Inc. credit spreads, we can generate the zero coupon bond yields on their promise to pay $1 in the future, which are shown in this graph:


The widening of zero coupon credit spreads, as we shall see below, comes about because the longest maturity bond issues of PepsiCo were lightly traded, distorting the credit spread a bit. If we discount dividend payments for maturities of 1, 10 and almost 30 years, we can solve for the “credit risk free” dividend for PepsiCo, Inc. This would be the dividend level for a default risk-free issuer (we assume as a first approximation that the U.S. Treasury is default risk-free) that has the same present value as the flow of dividends from PepsiCo, Inc. We use this data from

Readers who prefer a real time update of this information can see that here. After discounting the flow of dividends from PepsiCo at their current quarterly rate of $0.5675 and the present value factors implied by PepsiCo bond prices, we find that the long term credit-adjusted dividend yield is 2.301%, 0.34% less than the traditional dividend yield of 2.643% (note that the yield on the SeekingAlpha website is different because of lags in updating the figure as the stock price changes). Both calculations assume that the current dividends remain at their current level forever, except in the credit-adjusted case we recognize that PepsiCo, Inc. may default, ending the dividend stream. The bond-based discount factors recognize this fact. We show the calculation below for just the first 12 months of cash flows. We turn to the bond discount factors now.

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 all of the 15 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 PepsiCo, 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 PepsiCo, 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 PepsiCo, 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 of the PepsiCo, Inc. issues recorded by TRACE. The black dots and connecting black line show the yield consistent with the best fitting trade-weighted credit spread explained below.

The data shows that the credit spreads widen fairly steadily as maturity lengthens, the typical pattern for a high quality bond issuer. The longest maturity bonds of PepsiCo, Inc. on this day were very lightly traded, causing the bend in the curve on the right hand side of the graph.

The high, low and average credit spreads at each maturity are graphed below for PepsiCo, 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. Green dots which deviate significantly from this curve were very lightly traded.

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. For PepsiCo, Inc., the credit spread to default probability ratio generally ranges from about 17 on up for maturities of 2 years and under. For the longer maturities, the credit spread to default probability ratio falls in a range from 3 to 9 times.

The credit spread to default probability ratios are shown in graphic form below for PepsiCo, Inc.

How do these reward to risk ratios compare with “normal” levels? The best way to answer that question precisely 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 April 17. The distribution of the credit spreads on the 175 traded bonds that met these criteria on April 17 is first plotted in this histogram:

The median credit spread for all 175 trades was 0.782%. The average credit spread was 1.185%. The next graph shows the wide dispersion of the credit spread to default probability ratios on those 175 April 17 trades (only ratios of 40 or less are graphed):

The median credit spread to default probability ratio on those 175 trades was 8.17 and the average credit spread to default probability ratio was 14.47. PepsiCo, Inc.’s credit spread to default probability ratios ranked 6th and 94th out of all 175 trades on April 17, 2014. Here are the 20 “best trades” done April 17, 2014 that had the highest ratios of credit spread to default probability, along with the same data for the most heavily traded bonds of PepsiCo, Inc. We published a subset of this list Monday morning, focusing on maturities from 1 to 5 years, and PepsiCo, Inc. ranked among the top 20 bond issues.

Credit Default Swap Analysis
For the week ended April 11, 2014 (the most recent week for which data is available), the Depository Trust & Clearing Corporation reported there was 1 trade involving $1.1 million in notional principal on PepsiCo, Inc., ranking the firm the 502nd most actively traded reference name. Obviously, there was much more trading activity in the firm’s bonds than in the credit default swap market. The weekly number of credit default swap trades on PepsiCo, Inc. since the DTCC began publicizing weekly trade volume is shown here:

The notional principal of credit default swap trading on PepsiCo, Inc. over the same period is shown in this graph:

Additional Analysis
On a cumulative basis, the default probabilities for PepsiCo, Inc. range from 0.00% at 1 year to 1.02% at 10 years. We give the relative rankings of the company’s default probabilities below.

Over the last decade, the 1 year and 5 year annualized default probabilities for PepsiCo, Inc. have been very low, with the one year default probability barely exceeding 0.07% in 2004-2005. The annualized 5 year default probabilities reached an annualized 0.03% in 2009. This is a performance that every one of the “too big to fail” banks would envy.

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 PepsiCo, Inc. have been derived using historical data beginning in January 1990. 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 PepsiCo, 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, for which the results were announced in March. These macro factors explain 64.3% of the variation in the default probability of PepsiCo, Inc. The remaining variation is the estimated idiosyncratic credit risk of the firm.

PepsiCo, Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the U.S. “food, beverage, and tobacco” sector, PepsiCo, Inc. has the following percentile ranking for its default probabilities among its 42 peers at these maturities:

1 month        0th percentile, tied for lowest
1 year           0th percentile, tied for lowest
3 years         2nd percentile, second lowest
5 years         5th percentile, third lowest
10 years       2nd percentile, second lowest

These are among the best peer group percentile rankings we have found in this series of notes.

Comparison with Legacy Ratings
Taking still another view, the actual and statistically predicted credit ratings for PepsiCo, Inc. both show a rating in the upper middle of the “investment grade” territory. The statistically predicted rating is one notch below the legacy rating, those of Moody’s (MCO) and Standard & Poor’s (MHFI). The legacy credit ratings of PepsiCo, Inc. have changed just once in the last decade.

Before reaching a final conclusion about the “investment grade” status of PepsiCo, Inc., we look at more market data. First, we look at PepsiCo, Inc. credit spreads versus credit spreads on every bond in the “consumer products” sector that traded on April 17:

Credit spreads for PepsiCo, Inc. are among the lowest in the peer group. As we saw in the rankings above, PepsiCo, Inc. default probabilities are also among the very lowest in the peer group. We now turn to the legacy “investment grade” peers. We compare traded credit spreads on April 17, 2014:

Again, PepsiCo, Inc. credit spreads are solidly among the safest firms of the investment grade peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on April 17 also among the safest of all investment grade firms.

We believe a strong majority of analysts would rank PepsiCo, Inc. as “investment grade.” The bond market shows a PepsiCo, Inc. credit spread to default probability ratio that is 6th among 175 bond trades of $5 million or more on April 17, 2014. While the ratios for PepsiCo, Inc. longer maturities were not as attractive, they offer much more value, as measured by the credit spread to default probability ratio, than other consumer products companies in the “icon” class of bond issuers.

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.