In this note, we take a bond market look at one of the few companies in the world that still has the best possible legacy credit rating,Johnson & Johnson (JNJ). Why analyze a company that the rating agencies have given their best rating? That is a simple question to answer. AIG (AIG) had the rating agencies’ best rating in 2005, 3 years before its effective rescue and takeover by the U.S. government in 2008. FNMA and FHLMC both had the agencies’ highest rating on the day of their U.S. government conservatorship in September 2008, triggering an event of default under the rules of ISDA.org.
We seek to bring an independent bond market perspective to the outlook for Johnson & Johnson in today’s analysis. Today’s note incorporates Johnson & Johnson bond price data as of June 17, 2014. A total of 52 trades were reported on 12 fixed-rate bond issues of Johnson & Johnson with trading volume of $59 million. After eliminating debt issues that were either callable or not senior debt, we analyzed 9 debt issues on which there were 27 trades for $57 million.
Conclusion: It’s no embarrassment to agree with the rating agencies from time to time, and in this case it’s no surprise that we do. The best available statistical default probabilities for Johnson & Johnson are excellent. An overwhelming majority of analysts would rate Johnson & Johnson “investment grade” by the modern Dodd-Frank definition. Now that the obvious conclusion is out of the way, are the bonds good value? Surprisingly, 2 of the 3 most heavily traded bonds offer a credit spread to default probability ratio that is in the best 40% of all heavily traded bonds. Just as important, macro-economic factors explain only 11.9% of the variation in Johnson & Johnson default probabilities. If history is any guide to the future, Johnson & Johnson’s default risk is highly independent of the business cycle and for that reason alone the bonds are an interesting candidate for fixed income investors.
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 Johnson & Johnson to be “investment grade” under theJune 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 with 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. In this note, we also analyze the maturities where the credit spread/default probability ratio is highest for Johnson & Johnson.
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 (in green) for Johnson & Johnson ranging from one month to 10 years on an annualized basis versus its default probabilities six months earlier (in yellow). For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The default probabilities range from 0.00% at one month (the default probability is positive but goes to zero when rounding to two decimal places) to 0.00% at 1 year (same comment) and 0.07% at ten years.
We explain the source and methodology for the default probabilities in each Instablog published by Kamakura Corporation on SeekingAlpha.com.
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 bond issues mentioned above in this analysis. Looking at the totality of trading in Johnson & Johnson on June 17, the firm ranked 29th in the U.S. fixed rate corporate bond market for trading volume.
The graph below shows 6 different yield “curves” that are relevant to a risk and return analysis of Johnson & Johnson 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 Johnson & Johnson. 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 Johnson & Johnson 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 Johnson & Johnson 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.
The graph shows an increasing “liquidity premium” as maturity lengthens for the bonds of Johnson & Johnson. 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 Johnson & Johnson. 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 credit spreads peak slightly before the 20 year point and then decline, due to an excess of investor demand for very scarce long maturity bonds.
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 Johnson & Johnson, the credit spread to default probability ratio ranges from 4.500 times to 18.239 times. The ratios of spread to default probability for the senior non-call traded bond issues are shown here:
The credit spread to default probability ratios are shown in graphic form below for Johnson & Johnson.
Relative Value Analysis
Are these reward to risk ratios average? Are they above or below average? There is no need to guess. 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 June 17. On that day, there were 405 deals which met our criterion. We ignored legacy ratings in selecting the bonds to analyze. Of the 405 bonds, only 22 were rated below the legacy rating agency definition of “investment grade.”
The first graph plots the distribution of credit spreads for these 405 bond issues. The median credit spread was 0.820% and the average was 1.031%.
We then plot a histogram of our measure of “best value,” the ratio of credit spread to default probability. The median level of this ratio was 8.224 and the average was 12.996 on June 17.
How did the heavily traded bonds of Johnson & Johnson rank? There were 144 out of the 405 large trades on June 17 which had better credit spread to default probability ratios than the best ratio for any of the Johnson & Johnson bonds. The three heavily traded Johnson & Johnson bonds ranked 145 th, 158th, and 289th among all heavily traded bonds on June 17. The two best ranked bonds were in the top 40% on the value ranking scale.
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently prohibited by 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. In the meantime, CUSIPs for major issuers can be found easily with an internet such on web pages like this one from the New York Stock Exchange.
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 Johnson & Johnson 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 is important. If we discount dividend payments for maturities of 1, 10 and almost 30 years, we can solve for the “credit risk free” dividend for Johnson & Johnson 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 Johnson & Johnson over almost 30 years. We use this data from SeekingAlpha.com:
The history of Johnson & Johnson dividends is nicely summarized on the NASDAQ website.
Readers who prefer a real time update of the dividend yield information can see that here. After projecting the flow of dividends from Johnson & Johnson at the quarterly rate of $0.700 and using the present value factors implied by Johnson & Johnson bond prices, we find that the long term credit-adjusted dividend yield is 2.515%, 0.208% less than the traditional dividend yield of 2.723%. Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that Johnson & Johnson may default, ending the dividend stream. The bond-based discount factors incorporate this fact. The first two years of cash flow assumed and discount factors used are shown here to illustrate the methodology:
Credit Default Swap Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended June 13, 2014 (the most recent week for which data is available), the credit default swap trading volume on Johnson & Johnson was 21 contracts with notional principal of $337.8 million. The firm ranked 188th of 977 counterparties on which credit default swaps were traded during the week.
The weekly history of notional principal traded on Johnson & Johnson in the credit default swap market is shown in this graph:
The weekly history of the number of contracts traded on Johnson & Johnson in the credit default swap market is shown here;
On a cumulative basis, the default probabilities for Johnson & Johnson range from 0.00% at 1 year to 0.65% at 10 years.
Over the last decade, the 1 year and 5 year annualized default probabilities for Johnson & Johnson have remained at a low level that many of the largest financial institutions in the world would envy. The 1 year default probability peaked at slightly over 0.02% in 2009. The 5 year default probability peaked at slightly over 0.06% in 2006.
As explained at the end of the 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 Johnson & Johnson has 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 Johnson & Johnson default risk responds to changes in 5 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 11.9% of the variation in the default probability of Johnson & Johnson. This is the lowest proportion of systematic default risk that we have analyzed in this series of notes. The remaining variation, 88.1%, is default risk that is idiosyncratic to Johnson & Johnson.
Johnson & Johnson can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the USA “pharma and biotech” sector, Johnson & Johnson has the following percentile ranking for its default probabilities among its 445 peers at these maturities:
1 month 0 percentile, tied with 30 firms
1 year 0 percentile, 2nd lowest
3 years 0 percentile, lowest
5 years 0 percentile, 2nd lowest
10 years 1st percentile, 7th lowest
This is the best peer group ranking that we have analyzed in this series of notes. Taking still another view, the actual and statistically predicted Johnson & Johnson credit ratings both show a rating strongly in the “investment grade” territory. The statistically predicted rating is 6 notches below the legacy rating, those of Moody’s (MCO) and Standard & Poor’s (MHFI). The legacy credit ratings of Johnson & Johnson have never changed in the last decade.
Before reaching a final conclusion about the “investment grade” status of Johnson & Johnson, we look at more market data. First, we look at Johnson & Johnson credit spreads versus credit spreads on every bond in the healthcare and pharmaceuticals sector that traded on June 17:
Johnson & Johnson credit spreads were clearly at the lowest levels of the peer group. We now look at the matched maturity default probabilities on those traded bonds for both Johnson & Johnson and the peer group:
The default probabilities for Johnson & Johnson are at the bottom (best levels) of the industry peer group. We now turn to the legacy “investment grade” peers. First we compare traded credit spreads on June 17, 2014:
Again, Johnson & Johnson credit spreads are at the lowest end of the peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on June 17 are shown in this graph:
This comparison is again excellent.
It’s no embarrassment to agree with the rating agencies from time to time, and in this case it’s no surprise that we do. The best available statistical default probabilities for Johnson & Johnson are excellent. An overwhelming majority of analysts would rate Johnson & Johnson “investment grade” by the modern Dodd-Frank definition. Now that the obvious conclusion is out of the way, are the bonds good value? Surprisingly, 2 of the 3 most heavily traded bonds offer a credit spread to default probability ratio that is in the best 40% of all heavily traded bonds. Just as important, macro-economic factors explain only 11.9% of the variation in Johnson & Johnson default probabilities. If history is any guide to the future, Johnson & Johnson’s default risk is highly independent of the business cycle and for that reason alone the bonds are an interesting candidate for fixed income investors.
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.