Cisco Systems Inc. (CSCO) has launched the largest U.S. bond offering since last September, raising $8 billion in seven tranches. The fixed rate bonds issued as part of the Cisco offering were sold in these tranches: $2.4 billion of 1.1% notes due in 2017, $1.75 billion of 2.125% bonds due in 2019, $500 million of 2.9% bonds due in 2021 and $1 billion of 3.625% bonds due in 2024. This triggered a burst of trading activity in Cisco bonds on February 24, a day when Cisco Systems Inc. was the 16th most heavily traded issuer of fixed rate non-call senior debt in the U.S. market. There were 117 trades that day in 5 Cisco Systems Inc. bond issues with a trading volume of $76.1 million. Also on February 24, 2014, the bonds of Google Inc. (GOOG) were the 14th most heavily traded of any reference name, and the bonds of Apple Inc. (AAPL) were the 15th most heavily traded. This note compares the risk and return on Cisco Systems Inc. bonds with those of Google Inc. and Apple Inc., featured in yesterday's Kamakura bond analysis.
Conclusion: The data shows that Cisco Systems Inc. is "punching above its weight" relative to its peers with bonds traded on February 24, 2014. Its credit spreads on that day were only a bit higher than the spreads for Google Inc. and Apple Inc. even though its default probabilities have been much higher than the default probabilities for the other two firms for more than a decade. Its legacy credit ratings are also five notches higher than would be predicted by modern statistical methods. This is good news for common shareholders, but bad for bond holders. Cisco Systems Inc. bonds offered a reward to risk ratio that ranked only 275th of 333 large volume bond trades on February 24. Investors would receive twice as much spread per basis point of default risk if they bought Apple Inc. bonds instead.
This week is a rare opportunity to compare Cisco Systems Inc. bond risk and return with iconic high technology issuers Apple Inc. and Google Inc. We reviewed Apple Inc. in this series of notes on January 20, 2014. Google made its bond market debut in May, 2011. Google issued 3.375% notes due in 10 years last week, which is what has triggered higher trading volume in its bonds. A total of 76 trades were reported on February 24 on 4 fixed-rate non-call senior bond issues of Google Inc. with trading volume of $84.3 million. Of that volume, $67.3 million of trading volume was in the new 10 year Google bonds. For Apple Inc. there were 167 trades on 4 bond issues with an underlying trading volume of $80.2 million. We used all of that data in this note.
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 Cisco Systems 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 Cisco Systems 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 Cisco Systems Inc. (in green) 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. As a benchmark, we also show the annualized default probabilities for Google Inc. in yellow. The Cisco Systems Inc. default probabilities range from 0.16% at one month to 0.05% at 1 year and 0.39% at ten years. The ten year default risk figure is more than 4 times the ten year default probability that we reported for Google Inc. in yesterday's analysis.
We also explain the source and methodology for the default probabilities below.
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 13 (5 for Cisco Systems Inc. and 4 each for the other two firms) 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 Cisco Systems 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 Cisco Systems 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 Cisco Systems 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 Cisco Systems Inc. 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. Note that the black dots completely obscure the green because of the relatively small number of bonds traded.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Cisco Systems Inc. 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 Cisco Systems 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. The polynomial explains 99.98% of the variation in credit spreads over the maturity spectrum because there were only 5 traded bonds.
In the next graph, we compare the Cisco Systems Inc. trade-weighted average credit spreads (in blue) with the traded credit spreads of Google Inc. (in green) and Apple Inc. (in red, of course) bonds on the same day, February 24. Except for one Apple Inc. bond, credit spreads for Cisco Systems Inc. were modestly higher than the credit spreads for Google Inc. and Apple Inc.
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. In the following table, we show these results on February 24 for Cisco Systems Inc., along with the same results for Google Inc. and Apple Inc. For Cisco Systems Inc., the credit spread to default probability ratio generally ranges from 2.2 times (on the bonds due in 2019) to 4.2 times on the bonds due May 19, 2017. We omit the bonds very near to maturity. By comparison, the credit spread to default ratios for Apple Inc. range from 5.6 to 11.4 times. The credit spread to default ratios for Google Inc. range from 6.4 to 14.8 times (we again omit the bond near maturity). The ratios of spread to default probability for all traded bond issues for all three companies are shown here:
The credit spread to default probability ratios are shown in graphic form below for Cisco Systems Inc. The very short maturity bond, which is being refinanced by the new issues, has a very low credit spread to default probability ratio:
For better visibility, we plot the same ratios for Cisco Systems Inc. (in blue) alongside those for Google Inc. (in green) and Apple Inc. (in red). The graph makes it clear that the reward to risk ratio for Cisco Systems Inc. is well below that of the other two firms in the run-up to the Cisco Systems Inc. bond offering.
Are these reward to risk ratios "normal"? Are they above or below average? 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 February 24. The distribution of the credit spreads on 333 traded bonds that met these criteria on February 24 is plotted in this histogram:
The median credit spread was 0.95% and the average credit spread was 1.24%.
The next graph plots the credit spread to default probability ratio for Cisco Systems Inc. (dark blue) versus the other issuers with more than $5 million in trading volume on February 24. The line connects the median credit spread to default probability ratio for all issues.
The line varies because the issuers traded at each maturity point are different. The median spread to default probability ratio over the entire maturity spectrum was 11.09. The average spread to default probability ratio, skewed by some very high ratios, was 18.22. Because of the scale of the graph, it is not easy to see, but the dark blue dots representing the Cisco Systems Inc. credit spread to default probability ratios are well below the median for all 333 fixed rate non-call senior debt issues traded on February 24.
On February 24, 274 out of the 333 large trades had better credit spread to default probability ratios than the best ratio for any of the Cisco Systems Inc. bonds which traded at least $5 million in volume. Here are the 20 "best trades" done February 24, 2014 that had the highest ratios of credit spread to default probability. We have also reproduced the credit spread to default probability ratios for bond trades over $5 million in volume for Cisco Systems Inc., Google Inc. and Apple Inc. The Apple Inc. and Google Inc. trades all ranked better in value than the Cisco Systems Inc. bonds.
Credit Default Swap Analysis
The Depository Trust & Clearing Corporation ("DTCC") reports weekly on new credit default swap trading volume by reference name. During the week ended February 14, 2014 (the most recent week for which data is available), there were 6 credit default swap trades for $19.2 million on Cisco Systems Inc. Readers may recall there have never been any credit default swap trades on Google Inc. or Apple Inc. since the DTCC began reporting weekly in July 2010. The number of credit default swap contracts traded since July 2010 on Cisco Systems Inc. is shown in this graph:
The notional principal amounts of weekly trades in credit default swaps on Cisco Systems Inc. are shown in this graph:
On a cumulative basis, the default probabilities for Cisco Systems Inc. (in green) range from 0.05% at 1 year to 3.87% at 10 years. The cumulative default risk for Google Inc. (in yellow) is only one-fourth of the level of default risk at 10 years for Cisco Systems Inc.
Over the last decade, the 1 year and 5 year annualized default probabilities for Cisco Systems Inc. have been higher than its two technology peers. The 1 year default probability (in blue) peaked at about 0.30% in 2009. Google Inc. 1 year default probabilities (in yellow) were near 0.02% at their peak in 2008.
The 5 year annualized default probabilities for Cisco Systems Inc. (in blue) were near 0.32% in 2013-2014. The 5 year default probabilities for Google Inc. (in yellow) were as high as 0.10% in 2004-2005.
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 Cisco Systems Inc. have been derived using historical data since 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 Cisco Systems Inc. default risk responds to changes in 10 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 76.5% of the variation in the default probability of Cisco Systems Inc.
Cisco Systems Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the US "technology hardware and equipment" sector, Cisco Systems Inc. has the following percentile ranking for its default probabilities among its 315 peers at these maturities:
1 month 75th percentile
1 year 47th percentile
3 years 22nd percentile
5 years 16th percentile
10 years 16th percentile
Cisco Systems Inc. rankings show much higher risk relative to peer companies than we saw for both Google Inc. and Apple Inc. Taking still another view, the actual and statistically predicted Cisco Systems Inc. credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating, however, is 5 notches below the legacy rating, those of Moody's (MCO) and Standard & Poor's (MHFI). This means Cisco Systems Inc. is highly "overrated" by the legacy rating agencies. The legacy credit ratings of Cisco Systems Inc. have changed only once since 2006.
Before reaching any conclusions about the "investment grade" status of Cisco Systems Inc. under the new Dodd-Frank requirements, we look at the credit spreads for the firm compared to all trades of any size for all firms with a legacy ratings-based "investment grade" status. That comparison shows that credit spreads for Cisco Systems Inc. are lower than those for most investment grade firms traded on February 24, 2014.
The data shows that Cisco Systems Inc. is "punching above its weight" relative to its peers with bonds traded on February 24, 2014. Its credit spreads on that day were only a bit higher than the spreads for Google Inc. and Apple Inc. even though its default probabilities have been much higher than the default probabilities for the other two firms for more than a decade. Its legacy credit ratings are also five notches higher than would be predicted by modern statistical methods, so Cisco Systems Inc. is being treated with extreme kindness by the legacy rating agencies.
These facts are good for common shareholders and bad for potential investors in Cisco Systems Inc. bonds. We remind readers that a below average default probability is not sufficient reason to buy a bond. The bond must offer "good value," which we define in terms of the ratio of credit spread to the matching maturity default probability. By this measure, Cisco Systems Inc. bonds, in the run-up to the $8 billion offering, have a credit spread to default probability ratio that is less than half of the 11.09 median ratio of the 333 large-volume fixed rate bond trades on February 24. Indeed, the best value Cisco Systems bond trade on February 24 ranked only 275th best of the 333 total trades. Cisco Systems Inc. has higher default risk, by a considerable amount, than both Google Inc. and Apple Inc. but the reward to risk ratio on Cisco Systems Inc. bonds is far lower than the same ratios for Google Inc. and Apple Inc. For those investors who want a better reward to risk ratio and a similar iconic name, both Apple Inc. and Google Inc. bonds offer better value.
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.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.