The equity of Apple (AAPL) has arguably been the most topical large-cap stock in the world in 2013. The change in leadership given the untimely death of visionary co-founder and CEO Steve Jobs, related uncertainty around the company's product pipeline, the debate over how best to distribute the company's record cash hoard to shareholders, and the company's issuance of the largest corporate bond deal in history have all generated headlines and contributed to the stock's heightened equity volatility.
Of the 500 constituents of the S&P 500, Apple's trailing 180-day volatility has been the 46th highest, ranking between wireline telecommunications provider CenturyLink (CTL) and coal miner Consol Energy (CNX). For a company that intermittently has held the title as having the world's largest market capitalization, this is disconcerting company. Of the 78 largest components of the S&P 500, Apple has the highest year-to-date volatility, an annualized 35%.
It is fascinating, then, that another notable investment has had even greater price volatility than Apple's stock since its recent launch -- Apple's 30-year bonds. The table below details the price change of the AAPL 3.85% May 4, 2043, issue (CUSIP 037833AL4) since this $3 billion deal was brought on April 30 of this year and compares this bond's price volatility with that of Apple's stock.
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Why is it so surprising that Apple's bonds have been more volatile than its stock? Bonds are senior in the capital structure of the company, meaning that cash flows from the business must first flow to service the debt before paying distributions to equity holders. In the event of a bankruptcy these senior lenders have a claim over equity holders in the company's assets during the dissolution of the company.
Apple's debt is well covered, which is in part why the debt was rated with the second highest ratings from Moody's and Standard and Poor's, Aa1 and AA+, respectively. Some market participants debated whether that rating was high enough given that Apple had more cash on the balance sheet at time of issuance than every other AAA-rated company combined. The company's cash on the balance sheet, still covers the amount of debt by multiple times. If Apple does not appear to be at material risk of failing to repay bondholders, why have the bonds been so volatile?
The swings we have seen in interest rates since the issuance of Apple's bonds have driven the volatility. The credit spread of the Apple long bond has ranged from 100bps at issuance to a 95bp tight level shortly thereafter to the current wides of 115bps, or 1.15% over the on-the-run 30-year Treasury. The yield on the long Treasury bond has closed in a 58bp range, from 2.82% to 3.40%, between Apple's issuance and today.
This volatility is a function of the bond market's longer duration. Duration has a dual meaning in finance. It is a measure of the weighted average timing of future principal and interest cash flows, as well as a measure of interest rate sensitivity. Before Apple's $17 billion issuance became the largest bond deal in history, Roche held this title from its February 2009 issuance of $16.5 billion of bonds to finance the acquisition of Genentech. Roche, then rated A2/AA-/AA, issued $2.5 billion of 30-year bonds at a spread of 365bps, a coupon of 7% and a price of $97.28 to yield 7.23%. At issuance, the Roche bonds had a duration of 12.6 while the Apple long bonds had a duration of 18, over 40% higher.
The Apple bonds have a much longer duration because of their lower coupon at issuance, which means that it takes longer for the discounted value of future coupon cash flows to equate to half the value of the bond. Hearkening back to our dual definition of duration, this also means that the Apple bond is much more sensitive to a change in interest rates than previously issued high-quality long corporate bonds. For a 50bp parallel shift in interest rates, roughly equivalent to the move we have seen in long Treasuries since the Apple bond issuance, the 18 duration on Apple's long bonds means that they will fall in value by approximately nine points. For those keeping score at home, the bonds trade at between $90 and $91 today.
While I have used the topical performance of Apple for the purposes of illustration, Seeking Alpha readers should understand that long-duration bonds have been, and likely will continue to be, highly volatile investments. As I wrote in "How Risky Are Bonds? Stocks?" the 30-year Treasury bond has roughly the same trailing one-year realized volatility as the S&P 500, as demonstrated in the graph below. If these two assets have roughly the same risk in this market environment, but the average annual return of a 30-year bond held to maturity is 3.36%, which asset do you want to own?
Long-duration bonds are very risky in this low-rate environment that appears to be seeing a pickup in interest rate volatility, given the uncertainty about the future timing of quantitative easing. There has been a great deal of interest in the long part of the Treasury curve with ETFs providing exposure in unlevered form (TLT, TLO), levered form (UBT) and inverse unlevered (TBF) and inverse levered form (TBT, TMV, TTT). With an increase in interest rate volatility, these long duration instruments will see large price swings, and picking the right side of this trade will drive the investment performance of many investors.
I hope this example of the potential for extreme return volatility in even high-quality, long-duration fixed-income instruments like Apple's bonds informs the portfolio management and asset allocation decisions of Seeking Alpha readers.