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Donald R. Van Deventer, Ph.D.

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.

# Royal Dutch Shell Bond Issue Leads the 20 Best Value Bond Trades with Maturities of 1 Year or More

09/08/2014 08:28 AM

On September 5 in the U.S. bond market, there were 14,691 bond trades in 2,790 non-call fixed rate corporate bond issues representing $4,217,362,432 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 year or more. The answers to these questions are particularly important given the well-known inability of legacy credit ratings to match the accuracy of quantitative methods used in this series of notes. We ignore legacy ratings in this analysis for that reason. Conclusion: The 20 best-value non-call senior fixed rate bond trades with maturities of 1 year or more on September 5, 2014 were issues by these firms: SHELL INTERNATIONAL FINANCE BV (RDS.A) (RDS.B) WESTPAC BANKING CORPORATION (WBK) BANK OF MONTREAL (BMO) GOLDMAN SACHS GROUP INC. (GS), 4 issues JPMORGAN CHASE & CO. (JPM) AMGEN INC. (AMGN), 2 issues BOTTLING GROUP LLC (PEP) MANULIFE FINANCIAL CORPORATION (MFC) UNITEDHEALTH GROUP INC. (UNH) HOME DEPOT INC. (HD) AMERICAN TOWER CORPORATION (AMT) VENTAS REALTY LP (VTRB) FIFTH STREET FINANCE CORPORATION (FSC) AUSTRALIA AND NEW ZEALAND BANKING GROUP LTD. (ANZBY) SAFEWAY INC. (SWY) THERMO FISHER SCIENTIFIC INC. (TMO) Best Value Maturity Bond Trades for September 5, 2014 In analyzing the best trades of the day, we used these criteria: Bond type: Fixed rate Callability: Non-call Seniority: Senior debt Trade Volume:$5 million or more
Maturity:                 1 year or more
Ratings:                  Ignored
Survivor Option:     None

The most heavily traded bond issuers on September 5, 2014 are listed here:

We ignored legacy ratings in making today’s selection, but all but 10 of the 189 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 Vodafone Group PLC (VOD), AIG (AIG), AT&T (T) and IBM (IBM). 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 189 issues that met our criteria. The distribution of credit spreads is given in this histogram:

The median credit spread was 0.919%, and the average credit spread was 1.088%.

The distribution of the credit spread to default probability ratio is given in this histogram:

The median credit spread to default probability ratio was 9.737 and the average was 16.524. 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 Shell International Finance B.V. bond issue the winner at a reward to risk ratio of 172 times.

CUSIPs
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
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.

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.