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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

Dec 2

Written by: Donald van Deventer
12/2/2014 6:56 PM 

We last ranked the best value fixed rate corporate bond issues on October 17, 2014 for maturities of 20 years or more. Today we rank the best value corporate bond trades with daily trading volume of at least $5 million and maturities of 20 years or more. On December 1, 2014 in the U.S. bond market, there were 18,184 bond trades in 3,173 non-call fixed rate corporate bond issues of 982 bond issuers representing $5.2 billion in notional principal. Which 20 trades were the best trades of the day, and how do we decide the answer to that question?

Conclusion: We find the best-value non-call senior fixed rate 20 year maturity or longer bond trades on December 1, 2014 were issues by these firms:


Best Value 20 Year or Longer Bond Trades for December 1, 2014

In analyzing the best trades of the day, we used these criteria:

Bond type:                 Fixed rate until maturity
Callability:                 Non-call (except for make-whole calls)
Seniority:                   Senior debt
Trade Volume:          $5 million or more
Maturity:                    20 years or longer
Survivor Option:        Excluded
Index Linked:            Excluded
Ratings:                     Ignored

We ignored legacy ratings in making today’s selection, but all but 1 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 International Business Machines (IBM), Toyota Motor Company (TM), Citigroup Inc. (C), Cisco Systems Inc., Google Inc., Anheuser-Busch InBev S. A. (BUD), and Royal Dutch Shell PLC (RDS.A). 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 the daily default probability analysis posted by Kamakura Corporation. Both the credit spreads and default probabilities are reported as percent figures. The 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.

The most heavily traded bond issuers on December 1, 2014 are shown here:

The Scarcity of Long Term Bonds
The next graph shows that long term bonds are so scarce, relative to investor demand, that the average credit spread on heavily traded bond issues actually declines as maturity lengthens: 


Typical Relationship between Credit Spreads and Default Probabilities
The reason we do these rankings is that the relationship between credit spread and matched maturity default probability varies widely as the level of default risk rises, as shown in this graph: 


One of the main reasons for this volatility of spread with respect to default probability is the continued reliance of many investors on legacy credit ratings, in spite of the proven lack of accuracy documented by Hilscher and Wilson and the U.S. Senate Permanent Subcommittee on Investigations .

A Closer Look at the Relationship between Credit Spreads and Default Risk
When one calculates the ratio of credit spread to default probability for all traded corporate bonds and orders the results by default probability level, it is strikingly obvious that the ratio of credit spread to default probability declines as the level of risk increases. This is the “Las Vegas” phenomenon, in which people enjoy the process of gambling so much that they continue to do it even though the returns on gambling are inferior to safer bets. Here is the relationship between credit spreads and default probabilities on December 1, 2014: 


The Results of the Best Value Bond Rankings
In all, there were 30 issues that met our criteria. The distribution of credit spreads for the best value bond issues with maturities of 20 years or more is given in this histogram: 

The median credit spread was 1.713% and the average credit spread was 2.187%. The distribution of the credit spread to default probability ratio is given in this histogram: 

The median credit spread to default probability ratio was 7.199 and the average was 8.644.

Here are the ranking results, listed with the best ratio numbered 1, with an American Express Co. bond issue the winner at a reward to risk ratio of 25 times. A Philip Morris bond issue ranked second at 19 times. 


Appendix: Calculation Methodology and Related Data


Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently illegal under Kamakura Corporation’s contract with the data vendor. We are working hard to change this so that we may make CUSIPs available in the future. This article neatly summarizes which institutions have restricted availability of CUSIPs in order to maximize their profits as a monopoly supplier of the data. Thanks to FINRA, the CUSIPs have been put into the public domain for free via this FINRA-affiliated website.

Background on the Calculations
The use of default probabilities to make bond investors is new for many investors. For a guide to the advantages of using default probabilities in fixed income investment strategy, we recommend this overview published recently by J.P. Morgan Asset Management.

Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority, 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.

Author’s Note
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.