Novartis A.G. (NYSE:NVS) is one of the world's leading pharmaceutical companies. Like any iconic brand name, equity analysts have strong opinions on the stock, both positive and negative. On February 28, 2014, the bonds of affiliate Novartis Capital Corporation were the 12th most heavily traded of any reference name in the U.S. fixed rate corporate bond market. Bonds issued by Novartis Capital Corporation are fully and unconditionally guaranteed by the parent Novartis A. G. Today's note incorporates Novartis Capital Corporation bond price data to rank the company by both credit worthiness and relative value compared to other firms whose bonds traded that day. A total of 76 trades were reported on 5 fixed-rate non-call senior bond issues of Novartis Capital Corporation with trading volume of $106.3 million. We used all of that data in this note.
Conclusion: Novartis Capital Corporation bonds pose a challenge to investors: a low credit spread and a medium level of default probabilities result in a credit spread to default probability ratio that is only 20% of the median for all large trades on February 28. What is the best indicator of credit risk for Novartis A.G.? The legacy ratings, which are notoriously slow to adjust from high credit rating levels and which on average have been proven by Hilscher and Wilson ("Credit Ratings and Credit Risk," 2013) to be less accurate than statistical methods? Or the statistical methods that produce default probabilities using 1.76 million observations and 24 years of history? The good news is that investors don't need to make a judgment. In the chart below, we list 27 bonds in the healthcare-pharmaceutical sector that had better credit spread to default probability ratios than Novartis Capital Corporation.
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 Novartis Capital Corporation 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 Novartis Capital Corporation.
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 parent Novartis A.G. 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. The default probabilities range from 0.16% at one month to 0.06% at 1 year and 0.56% at ten years. We make the slightly optimistic assumption that the default probabilities for Novartis Capital Corporation are identical to those of the parent Novartis A.G.
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 5 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 Novartis Capital Corporation 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 (NYSEARCA:TLT)(NYSEARCA:TBT), interpolated from the Federal Reserve H15 statistical release for that day, which exactly matches the maturity of the traded bonds of Novartis Capital Corporation. 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 Novartis Capital Corporation 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 Novartis Capital Corporation 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 a narrowly increasing "liquidity premium" as maturity lengthens for the bonds of Novartis Capital Corporation. The surprise in the graph for Novartis Capital Corporation is how narrow the liquidity premium is versus the light blue "risk free curve plus default probability" line. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for Novartis Capital Corporation. 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 100% of the variation in credit spreads over the maturity spectrum because of the small number of bonds traded.
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 Novartis Capital Corporation, the credit spread to default probability ratio generally ranges from 1.2 times to 2.6 times. This is a very low level for the reward to risk ratio. The ratios of spread to default probability for all traded bond issues are shown here:
The credit spread to default probability ratios are shown in graphic form below for Novartis Capital Corporation.
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 28. The distribution of the 347 traded bonds that met these criteria on February 28 is plotted in this histogram:
The median credit spread to default ratio for all 347 trades was 9.71, more than 7 points higher than we found for Novartis Capital Corporation bonds. The mean credit spread to default probability ratio, skewed by a few very high ratios, was 15.55.
The next graph plots the credit spread to default probability ratio for Novartis Capital Corporation (dark blue) versus the other issuers with more than $5 million in trading volume on February 28. 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. Nonetheless, the dark blue dots representing the Novartis Capital Corporation credit spread to default probability ratios are well below the median at every point on the maturity spectrum.
334 out of 347 large trades on February 28 had better credit spread to default probability ratios than the best ratio for any of the Novartis Capital Corporation bonds which traded at least $5 million in volume. Here are the 20 "best trades" done February 28, 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 Novartis Capital Corporation and all other firms in the "healthcare-pharmaceuticals" sector. The Novartis Capital Corporation bonds ranked 335th and 336th of the 347 large trades on February 28.
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 February 21, 2014 (the most recent week for which data is available), there were no trades in either Novartis A.G. or Novartis Capital Corporation.
The graph of the gross weekly number of contracts traded on Novartis A.G. since July 2010 is shown here:
The notional principal of credit default swap trading on Novartis Capital Corporation over the same period is shown in this graph:
On a cumulative basis, the default probabilities for Novartis A.G. range from 0.06% at 1 year to 5.47% at 10 years. It is the latter figure which is a major contributor to the low credit spread to default probability ratios for Novartis Capital Corporation bonds.
Over the last decade, the 1 year and 5 year annualized default probabilities for Novartis A.G. have remained at moderate levels that many of the largest financial institutions in the world would envy. The 1 year default probability peaked at about 1.40% in 2008. The 5 year default probability peaked at slightly under 0.65% in 2004.
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 Novartis A.G. have 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 Novartis A.G. default risk responds to changes in 8 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 79.1% of the variation in the default probability of Novartis A.G. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Novartis A.G. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the world-wide "pharmaceuticals and biotech" sector, Novartis A.G. has the following percentile ranking for its default probabilities among its 1,363 peers at these maturities:
1 month 83rd percentile
1 year 54th percentile
3 years 39th percentile
5 years 45th percentile
10 years 46th percentile
Over a time horizon of 3 years or more, Novartis A.G. is in the safer half of the industry peer group, but not by much of a margin. Taking still another view, the actual and statistically predicted Novartis Capital Corporation credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is 5 notches, a major gap, below the legacy rating, those of Moody's (NYSE:MCO) and Standard & Poor's (NYSE:MHFI). The legacy credit ratings of Novartis A.G. have changed only once in the last decade.
Before reaching a final conclusion about the "investment grade" status of Novartis A.G., we look at more market data. First, we look at Novartis Capital Corporation credit spreads versus credit spreads on every bond in the "healthcare-pharmaceuticals" sector that traded on February 28:
Novartis Capital Corporation credit spreads were clearly lower than average for the peer group. We now look at the matched maturity default probabilities on those traded bonds for both Novartis Capital Corporation and the peer group:
The default probabilities for Novartis Capital Corporation are at the high end of the industry peer group. We note that the bonds trading heavily are generally a much better group of credits than the industry in aggregate. We now turn to the legacy "investment grade" peers. First we compare traded credit spreads on February 28, 2014:
Again, Novartis Capital Corporation credit spreads are at the very low end of the peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on February 28 are shown in this graph:
Again the default probabilities for Novartis Capital Corporation rank at or above the median for the investment grade peer group.
We believe that a majority of sophisticated analysts would rank Novartis Capital Corporation as an investment grade company. That being said, the quantitative default probabilities, particularly on the long-term end of the spectrum, are high from both an industry peer group perspective and from a legacy investment grade peer group perspective. The legacy credit ratings are 5 notches higher than the best possible statistical estimates of the rating for Novartis A.G.
We remind readers that a given default probability or rating 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, Novartis Capital Corporation bonds pose a challenge to investors: a low credit spread and a medium level of default probabilities result in a credit spread to default probability ratio that is only 20% of the median for all large trades on February 28. On the other hand, the two Novartis Capital Corporation bonds on the "large trade" list had very heavy volume. This is a classic opportunity for investors. What is the best indicator of credit risk for Novartis A.G.? The legacy ratings, which are notoriously slow to adjust from high credit rating levels and which on average have been proven by Hilscher and Wilson ("Credit Ratings and Credit Risk," 2013) to be less accurate than statistical methods? Or the statistical methods that produce default probabilities using 1.76 million observations and 24 years of history? The good news is that investors don't need to make a judgment. In the chart above, we list 27 bonds in the healthcare-pharmaceutical sector that had better credit spread to default probability ratios than Novartis Capital Corporation.
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.