Caterpillar Inc. (NYSE:CAT) is the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. Caterpillar Inc. issues bonds both in its own name and via Caterpillar Financial Services Corporation. Caterpillar Financial Services Corporation is the beneficiary of a support agreement, not a guarantee, from Caterpillar Inc. In this note, we turn to the U.S. dollar bonds issued by Caterpillar Financial Services Corporation and compare its current default probabilities and credit spreads with those on all heavily-traded corporate fixed-rate bonds on June 24, 2014. A total of 109 trades were reported on 24 fixed-rate bond issues of Caterpillar Financial Services Corporation with June 24 trading volume of $88 million.
Conclusion: We believe that a majority of sophisticated analysts would rank Caterpillar Inc. as "investment grade" because of its long-run default probability ranking in the best 3% of the general industrial peer group. Caterpillar Inc. also ranks number 60 on Forbes' world's most valuable brands list. What is a surprise to us is that Caterpillar Inc. and Caterpillar Financial Services Corporation bonds offer above average value, because we have seen often that "brand name" firms' bonds trade at a brand name premium. On June 24, only 7 of 433 heavily-traded bonds offered a better credit spread to default probability ratio than the best Caterpillar Inc. bond issue. The bulk of the Caterpillar Inc. and Caterpillar Financial Services Corporation bond issues were solidly in the best value half of the heavily-traded universe.
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 Caterpillar Inc. to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. For a discussion of the implications of the Dodd-Frank Act on the definition of investment grade, see our post on Citigroup in December.
Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority for 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 to default probability ratio is highest for Caterpillar Inc. and Caterpillar Financial Services 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 Caterpillar Inc. (green line) ranging from one month to 10 years on an annualized basis. As a first approximation, we make the optimistic assumption that these default probabilities also apply to Caterpillar Financial Services Corporation. We plot the current default probabilities versus the default probabilities for Caterpillar Inc. six months earlier on December 24, 2013 (orange line). For maturities longer than ten years, we assume that the ten-year default probability is a good estimate of default risk. The current Caterpillar Inc. default probabilities range from 0.00% at one month (the default probabilities are positive but round to zero at two decimal places) to 0.00% at 1 year (same comment) and 0.09% at ten years.
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. The total of all fixed rate debt issued by both Caterpillar Financial Services Corporation and Caterpillar Inc. and traded on June 24 is reported here. Caterpillar Financial Services Corporation was the 18th most actively traded issuer. Caterpillar Inc. was the 100th most actively traded issuer but we do not use those bonds in this analysis. We will compare the two entities in a subsequent post.
After eliminating callable bonds and non-senior bonds from the total for Caterpillar Financial Services Corporation, we analyzed 106 trades on 23 issues with a notional principal traded of $87.9 million.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Caterpillar Financial Services 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 matches the maturity of the traded bonds of the Caterpillar Financial Services 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 line graphs the lowest yield reported by TRACE on that day on Caterpillar Financial Services Corporation bonds. The green line displays the value-weighted average yield reported by TRACE on the same day. The red line is the maximum yield in each Caterpillar Financial Services Corporation bond issue recorded by TRACE. The black dots and connecting black line represent the yields consistent with a trade-weighted fitted credit spread we discuss below.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Caterpillar Financial Services Corporation. This increasing liquidity premium 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 Caterpillar Financial Services Corporation. We have done nothing to smooth the data reported by TRACE (other than eliminating erroneous data as explained above), which includes both large lot and small lot bond trades. For the reader's convenience, we fitted a trade-weighted cubic polynomial that explains the average spread as a function of years to maturity.
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 Caterpillar Financial Services Corporation, the credit spread to default probability ratio ranges from 6 to more than 100 times. 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 Caterpillar Financial Services Corporation.
Relative Value Analysis
How does the credit spread to default probability ratio for Caterpillar Financial Services Corporation compare to other bonds available in the market place? Is it high, low or average? We answer that question by comparing the credit spread to default probability ratio for Caterpillar Financial Services Corporation with all 433 bond issues with a daily trading volume of at least $5 million on June 24 and a maturity of 1 year or more. The first graph shows a histogram of the credit spreads that prevailed on these issues on June 24, 2014:
The median credit spread was 0.889% and the average was 1.149%. The distribution of the reward to risk ratio, the credit spread divided by the matched maturity default probability, is shown in the next histogram. The median ratio is 8.58 and the average ratio is 13.18.
The ratio of credit spread to default probability is shown in this chart for all of the Caterpillar Inc. and Caterpillar Financial Services Corporation bonds with at least $5 million in trading volume. All 6 of the Caterpillar Inc. and Caterpillar Financial Services Corporation bonds rank above the 217th bond, the median of all heavily-traded bonds when ranked by our value criterion. Overall, the Caterpillar Inc. and Caterpillar Financial Services Corporation bonds rank 8th and then cluster in a range from 158 to 198 of the 433 heavily-traded bonds.
For a recent ranking of heavily-traded bonds with maturities of one to 5 years, please see this ranking from June 16, 2014.
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 (NYSE: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 Caterpillar Financial Services Corporation 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 Caterpillar Inc. 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 Caterpillar Inc. over almost 30 years. We use this data from SeekingAlpha.com:
The history of Caterpillar Inc. 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 Caterpillar Inc. at the quarterly rate of $0.70 and using the present value factors implied by Caterpillar Inc. bond prices, we find that the long-term credit-adjusted dividend yield is 2.527%, 0.060% less than the traditional dividend yield of 2.587% (note that the yield on the SeekingAlpha website is different because of lags in updating the figure as the stock price changes). Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that Caterpillar Inc. may default, ending the dividend stream. The bond-based discount factors incorporate this fact. We show the calculation below for just the first 24 months of cash flows.
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 20, 2014 (the most recent week for which data is available), the credit default swap trading volume on Caterpillar Inc. was 39 trades for $234 million, ranking the firm 203rd among 977 counterparties with at least one trade during the week.
The notional principal traded weekly in the credit default swap market on Caterpillar Inc. is shown in this graph of data from the Depository Trust & Clearing Corporation:
The number of credit default swaps traded weekly on Caterpillar Inc. is shown in this history graph:
On a cumulative basis, the current default probabilities (in green) for Caterpillar Inc. range from 0.00% at 1 year (after rounding) to 0.89% at 10 years. The December 24, 2013 cumulative default probabilities are graphed in orange.
Over the last decade, the 1-year and 5-year annualized default probabilities for Caterpillar Inc. spiked during the credit crisis. The 1-year default probability (in blue) peaked at slightly over 0.65% in 2008-2009. The 5-year default probability (in yellow) peaked at slightly over 0.30% on an annualized basis at the same time.
The firm's default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. For an explanation, see the references in each Instablog posted by Kamakura Corporation. 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 Caterpillar Inc. 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 Caterpillar Inc. default risk responds to changes in 8 risk factors among the macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 76.0% of the variation in the default probability of Caterpillar Inc. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Caterpillar Inc. can be compared with its peers in the same industry sector, as defined by Caterpillar Inc. itself and reported by Compustat. For the USA "capital goods" sector, Caterpillar Inc. has the following percentile ranking for its default probabilities among its 395 peers at these maturities:
1 month 0th percentile, tied with many firms
1 year 0th percentile, tied with many firms
3 years 13th percentile,
5 years 3rd percentile,
10 years 3rd percentile,
Over a longer time horizon, Caterpillar Inc. ranks in the safest 3% of its peer group from a credit risk perspective.
Taking still another view, the actual and statistically predicted Caterpillar Inc. credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is 1 notch below the legacy rating from firms like the Standard & Poor's affiliate of McGraw-Hill (MHFI) and Moody's Investors Service (NYSE:MCO). The legacy ratings of the company have not changed in the last decade.
We postpone our conclusions briefly to view some more facts. The "general industrial" peer credit spreads on June 24 are shown here in light blue, with Caterpillar Inc. credit spreads plotted in dark blue. Caterpillar Inc. credit spreads are slightly below the median.
The matched maturity default probabilities for the "general industrial" peer group with bonds traded on June 24 are shown in this graph:
Caterpillar Inc. is roughly at or below the middle of the peer group by this measure. Investment grade credit spreads on all bonds traded on June 24 are shown here in light blue with Caterpillar Inc. credit spreads plotted in dark blue:
Caterpillar Inc. falls well below the middle of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus Caterpillar Inc.:
Caterpillar Inc. is again near the safest part of the investment grade peer group.
It is no surprise that we believe that a majority of sophisticated analysts would rank Caterpillar Inc. as "investment grade" because of its long-run default probability ranking in the best 3% of the general industrial peer group. Caterpillar Inc. also ranks number 60 on Forbes' world's most valuable brands list. What is a surprise to us is that Caterpillar Inc. and Caterpillar Financial Services Corporation bonds offer above average value, because we have seen often that "brand name" firms' bonds trade at a brand name premium. On June 24, only 7 of 433 heavily-traded bonds offered a better credit spread to default probability ratio than the best Caterpillar Inc. bond issue. The bulk of the Caterpillar Inc. and Caterpillar Financial Services Corporation bond issues were solidly in the best value half of the heavily-traded universe.
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 Seeking Alpha, 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: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.