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Transcript of First Data Bond Swap
Roland George Investments Program
Bond Swap Recommendation
Eric Ebersole
03/29/15 `
Buy Candidate Analysis
First Data Corporation is a global payment technology solutions company headquartered in Atlanta,
Georgia that provides electronic commerce and payment solutions. The company operates merchant
transaction processing services including credit, debit, private-label, gift, payroll and other prepaid card
offerings such as fraud protection and authentication solutions, credit reporting agency services. First
Data also provides electronic check acceptance services through TeleCheck as well as Internet commerce
and mobile payment solutions. The company’s STAR interbank network offers PIN-secured debit
acceptance at ATM and retail locations.
I believe that First Data is attractive to bondholders for three reasons: increased focus on cash flow
growth, Moody’s positive outlook, and improved financial health. First Data’s fourth quarter was its
strongest since going private in 2007. Q4 revenue grew 3% to $11,151 million while operating profits
grew an astounding 28% to $1,4393million. While revenues have increased First Data has been able to
keep costs low resulting in a 2% decrease in cost of services and a 7% decrease in interest expense
showing financial health in areas important to bondholders. Net cash provided by operating activities
grew 28% for Q4 and 51% for 2014. The strong Q4 is a great sign for stable growth in 2015 and will
keep bondholders calm as First Data has proven its ability to satisfy debt obligations and continue to grow
its cash flow. Net cash provided by operating activities 27.9% for Q4 in comparison with Q4 2013 and
50.6% year over year. First Data’s ability to maintain cash flow growth enables bondholders to be paid
since the cash flows are being kept within the company and not being used to finance large scale
acquisitions. Moody’s affirmed its B1 rating for First Data’s debt on June 20, 2014 and changed its
Sell Candidate Buy Candidate
ArcelorMittal Company First Data Corp
9.85% Coupon 8.875%
06/01/2019 Maturity 08/15/2020
4.944 YTM 7.391
3.387 Modified Duration 4.447
0.146 Convexity 0.243
$121.39/$121.88 Price (Bid/Ask) $106.50/$107.00
$121.00 Cost Basis N/A
BB Rating (S&P) BB-
Straight Optionality Callable
Materials Sector Financials
N/A Basis Point Pickup 318
4.353 Portfolio Duration 4.452
outlook to positive. The positive outlook reflects “Moody’s expectation that First Data will gradually
reduce adjusted debt to EBITDA toward 7 times over the next two years. Following the redemption of
debt using the net proceeds from the equity raise, First Data’s debt leverage will decrease to below 8
times from over 9.5 times on a Moody’s adjusted basis”.1 Bond holders should be encouraged by this
outlook because this rating is “supported by the company’s scale and leading position in electronic
commerce and payment solutions for financial institutions and will be able to profit from the ongoing
shift of payment method to electronic cards from cash and checks”. Lastly, with the recent addition of
equity, $3.5 billion, First Data has been able to alter its capital structure so that they were able to pay
down debts and decreased annual cash interest payments by $228 million. This decrease in liabilities will
benefit the bondholders as there is a decrease in default risk and this change in structure helps to free up
more cash creating stability in the financials of the company. First Data has been at the forefront of
technology for banking services since the 1970’s and is poised to continue this trend.
Interest Rate Level Forecast
The labor market has continued to stay strong as expected average monthly job gains for 2015 is 260,000,
or about 3.1 million for the year, which mirrors 2014. Unemployment is down to 5.5 from 6.7 just one
year ago and is expected to finish the year at 5.3 which would be its lowest since April 2008.2 Wage
growth is poised to increase to 2.5% after remaining at 2% for a majority of the second half of 2014.
Inflation will remain low this year still below the Federal Reserve’s 2% target influenced by the dollar
strengthening causing prices of imported commodities to decline.3 Consumer prices also saw only 0.8%
growth last year helping to add to the stability of inflation. With continued low oil prices, oil companies
are starting to feel the negative affects with greater severity. This affect should help to cause a decline in
oil production leading to a rebound in oil prices; however they will not rebound more than $20 over the
next four months. These low oil prices have helped lead to an increase in consumer spending helping to
add to the increase growth in GDP after an upturn of 3.87% during 2014. However, I believe that this
will be out shadowed by the end of the year as the economy begins to slow as predicted. The slowing of
the U.S. economy will lead to a decrease of 10 basis points in interest rates.
On March 18th Federal Reserve Chairwoman Janet Yellen announced that a reference to being “patient”
on rates was removed from its policy statement. While this could entice investors to believe that a hike
could come in the next few months Yellen followed by saying that this change does not mean they are
going to act impatiently. The next scheduled meeting is in April but it is very unlikely that rates will be
raised this soon. There is not enough wage or price pressure to influence the Fed to raise rates soon. The
news of this decision led to a surge in the stock market showing a positive response. However, the Fed
“cut its inflation outlook for 2015 and reduced expected U.S. growth”.4 I believe that the Fed will
continue to wait until data shows that the labor market has improved and inflation is poised to move back
to its 2 percent target. This decision to cut its projection for the economy comes months after they cited
that economic activity was expanding at a solid pace. The yield curve remains fairly narrow around the 5
year mark but I believe this will continue to stay relatively the same. I believe the Federal Reserve’s
actions, along with market anticipation, will cause interest rates to increase 10 basis points.
The European Central Bank announced it would be implementing a quantitative easing program on
January 22nd
. This move could lead to the Euro reaching parity with the dollar and will help high-debt
economies benefit from lower borrowing costs and reduced interest rates. Countries such as Spain,
Ireland, Italy, and Portugal look to gain while Greece, the fifth member of the PIIGS grouping, has been
1 https://www.moodys.com/research/Moodys-affirms-First-Data-Corps-B3-CFR-outlook-changed-to--PR_302294
2 http://data.bls.gov/timeseries/LNS14000000
3 http://www.kiplinger.com/tool/business/T019-S000-kiplinger-s-economic-outlooks/
4 http://www.reuters.com/article/2015/03/18/us-usa-fed-idUSKBN0ME0D520150318
excluded from the QE as the ECB is waiting for the Greek bonds they purchased previously to mature this
summer.5 There continues to be uncertainty in Greece even though they were able to provide $2.17 billion
due on March 20th. “Greece made a deal on February 20
th with the finance ministers of its European
Union partner to extend its $257 billion bailout package by four months, to June”.6 $7.5 billion is still
being withheld until Greece is able to provide a list of measures to increase tax revenue, contain spending,
and overhaul the economy so that the creditor find it stable enough to use the loan efficiently.7 I believe
that the geo-political risks will continue the current flight to quality causing downward pressure on the
interest rates leading to the stability of rates ensuring they stay just above 2%. I believe that while there is
uncertainty overseas the geopolitical risks will decrease rates by 30 basis points.
The credit spread was stable until the latter half of 2014 seeing a separation due to market conditions
caused by the collapse in oil prices and continued uncertainty in Europe. However, the credit spread
currently rests at the long term average of 1.3%. The average spread is currently well above 0.97%, the
2014 low. The high-yield bond market is sensitive to credit spread movements and saw spikes aligned
with “sell-offs in the equity market, illustrating that high-yield corporate bonds are more closely
correlated with the U.S. stocks than they are with U.S. treasury bonds”.8 While the high-yield bond
5 http://www.newsweek.com/germany-and-greece-losers-ecbs-quantitative-easing-plan-313740
6 http://www.nytimes.com/2015/03/21/business/international/merkel-warns-that-greece-will-receive-aid-only-if-
reforms-are-met.html?_r=0 7 http://www.nytimes.com/2015/03/21/business/international/merkel-warns-that-greece-will-receive-aid-only-if-
reforms-are-met.html?_r=0 8 http://www.nytimes.com/2015/03/21/business/international/merkel-warns-that-greece-will-receive-aid-only-if-
reforms-are-met.html?_r=0
market only contains a small percentage of oil field service companies, 1.7%, there has been an increase
in chance of defaults. As oil continues to stabilize the high-yield bond market will receive a boost in
returns from the narrowing spread. As displayed by the growth showing both the spot and future rates of
the treasury curve, the difference seems to be stable.
Given the current market conditions and state of the U.S. economy, geopolitical risks overseas, and
narrowing spread, I believe that interest rates will decrease by 25 basis points.
Stock Market Outlook
The stock market relies heavily on a stable, growing economy. As I mentioned above the economy is still
growing, yet will begin to slow in 2016. This will begin the end of a historic bull market that has lasted 6
years. The current bull market is poised to continue through 2015 but will certainly see a slow compared
to the recent momentum seeing a double digit return in each of the last three years. The Dow Jones
Industrial Average has continued to stay above the Composite of 16 NDR-Defined Cyclical Bull Markets
within Secular Bull Markets since 1900. A market correction is due to come as markets soared upon
hearing the recent news from Chairwoman Yellen that a rate hike would likely be pushed back Even with
the impending rate hike bull markets historically have absorbed these increases. This does not come
without a correction as the market will take a down turn once rates are raised. Historically, the U.S. stock
market has experienced a 20% market correction every 635 trading days. It has been over 1,500 trading
days since such a severe correction has occurred. I believe this will dampen returns leaving the end of
year results under 10%. The strength of the economy currently provides a great platform for the market
to continue its rise for the remainder of the year, but will lag behind the recent success causing this to be
the first year of single digit returns since 2011 ending the year at 8%.
Swap Rationale
As the United States continues its stability in areas such as GDP, unemployment, and wage growth
investors will continue their trend of flight to quality in response to geo-political risks currently occurring
in Europe as a result of Greek’s financial struggles as well as Russia’s currency deterioration. I believe
that this will cause downward pressure upon interest rates but by then end of our workout period will
slightly increase by approximately 25 basis points. I believe that with the decreasing credit spread it is
beneficial for the portfolio to pursue a lower rated bond as the credit risk is decreasing. I forecasted that
the financials sector will help decrease our oil exposure but still keep us in risky, yet profitable industry
helping us to increase our return as evident from the 6 basis point pick up from the sector source of profit.
Assuming that my predictions are correct, replacing MTNA with FDC would be beneficial and maximize
total returns.
First Data has a history of being at the forefront of the ever-changing financial services energy. With the
market’s move towards nearly removing paper currency and checks from everyday use First Data is
positioned well to benefit from a paradigm shift. This market shift will enable First Data to increase their
free cash flow growth enabling them to appear more attractive to bondholders. This growth will facilitate
First Data’s responsibility to pay back bondholders consistently for their investment. With First Data’s
ability to process 2,000 transactions a second totaling $1.8 trillion a year, First Data has the opportunity to
continue its profitability throughout our workout period.
Because I forecast that interest rates will decrease First Data’s higher duration will help us increase our
basis point pickup. In order to determine this affect I found a similar bond to ArcelorMittal but with a
duration mirroring First Data. In the scenario using Suzano Trading and Titan Global as comparables
there is 162 basis points of pickup. I believe that the characteristics of the bond and the sources of swap
profit are beneficial to the portfolio in such an even balance that even if we do take a large hit from any of
our risk exposures only a small proportion of our return will be affected.
With the massive geo-political events that are currently underway in Europe, I feel that it is in the
portfolio’s best interest to swap for a bond that is US based, as opposed to ArcelorMittal which is based
out of Luxembourg. By doing so, not only will we maximize returns, but also decrease some political
risks as well as oil exposure. I believe that swapping out of our position in ArcelorMittal and into First
Data will benefit the portfolio’s overall return.
Regression Analysis
Yield Movement
I used a regression model to calculate the relationship between my buy candidate, First Data, and the
S&P500 as well as the Treasury. In order to determine this relationship I used the below equation:
ΔiFirst Data = 0.074 + 0.293*25 – 0.130*800 = -96.63 bps
ΔiArcelorMittal = -0.043 + -0.196*25 – 0.018*800 = 9.78 bps
I used my forecasted interest rate and estimated market return to calculate the projected change in basis
points for each bond’s yield. By doing this I found that First Data’s yield would decrease 96 basis points
while ArcelorMittal’s yield would increase 10 basis points. However, by analyzing the yield charts I find
it unlikely that First Data will drop close to 100 basis points because the lowest point in the yield is
6.74%. I believe that First Data will drop due to its undervaluation and increased risk pickup using the
regression only as a tool. Due to this result I believe the most probable scenario is for First Data’s yield
to decrease by 50 basis points and for ArcelorMittal’s yield to stay at its current level.
Fair Value for ArcelorMittal
In order to determine the fair value for ArcelorMittal I utilized the fair value function on Bloomberg. As
illustrated by the graph below the spread for ArcelorMittal is 53.1 basis points when compared to the
USD Composite BB BVAL Curve. I then multiplied the spread by ArcelorMittal’s duration, 3.387,
which rendered an undervaluation of 1.80%.
Fair Value for First Data Corporation
In order to find the fair value for First Data I began by finding three bonds that mirrored First Data’s yield
to maturity, modified duration, convexity, rating, optionality, and sector. I then found the average of the
three yields of the comparable bonds, 6.617, and multiplied the difference by the negative duration of
First Data, 4.447. This calculation indicates that First Data is undervalued by 344 basis points or 3.44%.
By finding the fair value for both ArcelorMittal and First Data we can see that First Data is 1.64% more
undervalued than ArcelorMittal.
Company First Data Shimao Property
Holdings KCG Holdings
Theta Capital Ptd
Ltd
Coupon 8.875% 6.625% 6.875 7%
Maturity 08/15/2020 01/14/2020 03/15/2020 04/11/2022
YTM 7.391% 6.546% 7.270% 6.037%
Modified Duration 4.447 4.004 4.115 4.095
Convexity 0.243 0.196 0.206 0.209
Price $106.50 $99.62 $98.00 $103.25
Rating BB- BB- BB- BB-
Optionality Callable Callable Callable Callable
Sector Financials Financials Financials Financials
Mispricing -344
Interest Rate Stress Test
To support why I believe that the swap would benefit the portfolio, I performed an interest rate stress test
with 50 different movement combinations to ArcelorMittal and First Data’s yield to maturity. As the table
indicates, each of the different movement combinations results in a different basis point pick-up and P&L.
The most likely scenario that I believe will occur based upon my interest rate forecast and market outlook
is bold and italicized. From all of the 50 different scenarios, the portfolio would see basis point pickup
from 36 of the movements, or approximately 72%. The remaining 14 scenarios, 18%, would result in a
loss of basis points. The fact that 72% of these various scenarios results in a basis point gain is a
reassurance that even if interest rates do the opposite of what I forecast we will see a return in the
portfolio. Although that is reassuring, I do not foresee ArcelorMittal losing a significant amount of basis
points from their yield over the next 12-18 months due to the fact that investors are likely to remain
stagnant over the uncertainty of the geopolitical events previously discussed. Investors are likely to
engage in a flight to quality movement, which will likely keep rates low and only allow them to rise
slightly. The average basis point pickup observed from the test yielded 196 bps ($19,748), while the most
positive and negative results yielded 665 bps ($82,734) and -353 ($-43,918), respectively. Considering
this when examining the possible scenarios, I predict that First Data’s yield will decrease by 50 bps and
ArcelorMittal’s yield to remain at its current level providing a 380 basis point pickup ($43,008). It is
clear from the stress test results that First Data would serve as an excellent swap candidate to maximize
our portfolio returns in various interest rate movement scenarios.
FDC MT Spread FDC YTM MT YTM Net P/L BP Pick-up
No Move No Move 244 7.38 4.952 $19,165 154
No Move Up 30 214 7.389 5.252 $28,753 231
No Move Up 60 184 7.389 5.552 $38,242 307
No Move Up 90 154 7.389 5.852 $47,634 383
No Move Down 30 274 7.389 4.652 $9,478 76
No Move Down 60 304 7.389 4.352 $-310 -3
No Move Down 90 334 7.389 4.052 $-10,200 -82
Up 30 No Move 274 7.689 4.952 $7,775 63
Up 30 Up 30 244 7.689 5.252 $17,363 140
Up 30 Up 60 214 7.689 5.552 $26,852 216
Up 30 Up 90 184 7.689 5.852 $36,244 291
Up 30 Down 30 304 7.689 4.652 $-1,912 -15
Up 30 Down 60 334 7.689 4.352 $-11,700 -94
Up 30 Down 90 364 7.689 4.052 $-2,1590 -174
Up 60 No Move 304 7.989 4.952 $-3,463 -28
Up 60 Up 30 274 7.989 5.252 $6,124 49
Up 60 Up 60 244 7.989 5.552 $15,613 126
Up 60 Up 90 214 7.989 5.852 $25,005 201
Up 60 Down 30 334 7.989 4.652 $-13,151 -106
Up 60 Down 60 364 7.989 4.352 $-22,939 -184
Up 60 Down 90 394 7.989 4.052 $-32,829 -264
Up 90 No Move 334 8.289 4.952 $-14,553 -117
Up 90 Up 30 304 8.289 5.252 $-4,966 -40
Up 90 Up 60 274 8.289 5.552 $4,524 36
Up 90 Up 90 244 8.289 5.852 $13,916 112
Up 90 Down 30 364 8.289 4.652 $-24,240 -195
Up 90 Down 60 394 8.289 4.352 $-34,028 -274
Up 90 Down 90 424 8.289 4.052 $-43,918 -353
Down 30 No Move 214 7.089 4.952 $30,709 247
Down 30 Up 30 184 7.089 5.252 $40,296 324
Down 30 Up 60 154 7.089 5.552 $49,786 400
Down 30 Up 90 124 7.089 5.852 $59,178 476
Down 30 Down 30 244 7.089 4.652 $21,022 169
Down 30 Down 60 274 7.089 4.352 $11,234 90
Down 30 Down 90 304 7.089 4.052 $1,344 11
Down 50 No Move 194 6.892 4.952 $43,008 318
Down 60 No Move 184 6.789 4.952 $42,408 341
Down 60 Up 30 154 6.789 5.252 $51,996 418
Down 60 Up 60 124 6.789 5.552 $61,485 494
Down 60 Up 90 94 6.789 5.852 $70,877 570
Down 60 Down 30 214 6.789 4.652 $32,721 263
Down 60 Down 60 244 6.789 4.352 $22,933 184
Down 60 Down 90 274 6.789 4.052 $13,043 105
Down 90 No Move 154 6.489 4.952 $54,266 436
Down 90 Up 30 124 6.489 5.252 $63,853 513
Down 90 Up 60 94 6.489 5.552 $73,343 590
Down 90 Up 90 64 6.489 5.852 $82,734 665
Down 90 Down 30 184 6.489 4.652 $44,579 358
Down 90 Down 60 214 6.489 4.352 $34,791 280
Down 90 Down 90 244 6.489 4.052 $24,900 200
The previous table shows a stress test on potential interest rate movements on both bonds. The scenarios
that are most likely to occur are italicized. A majority of scenarios increase our portfolio return. Majority
of time when we would lose money it would be when First Data’s yield goes up coupled with a decrease
in ArcelorMittal’s yield. The best possible scenario is bolded and produces a 318 basis point pickup with
a profit of $43,008.
Credit Stress Test
Although the interest rate stress test shows promising signs for the swap into First Data, it is important to
conduct a credit stress test to see the impact on the portfolio should the bond we are looking at purchasing
become downgraded. In order to perform this test I found a bond that had similar characteristics to First
Data, but one credit rating lower and then another that is two credit ratings lower. I then found the spread
between the yield of First Data and each of the lower rated bonds. After finding the yield I multiplied
each of the spreads by First Data’s duration in order to determine what impact there would be on the
portfolio in the event that First Data is downgraded once or twice. By performing this test it I concluded
that should First Data be downgraded the portfolio would lose 124 Basis points. The same concept was
applied if First Data were to receive two downgrades during our holding period which displayed a drop of
380 basis points. Despite the test results, I see no need for concern given that Moody’s outlook was
changed from stable to positive during June 2014 and the outlook for 2015 is promising. I predict it
highly unlikely that First Data will receive a downgrade and even more unlikely two downgrades during
our workout period, or even past it.
New Bond Comparable Bonds
Down Grade
First Data Corp Company Nationstar Mort/Cap
Corp Jefferies Fin LLC
8.875% Coupon 7.875% 7.500%
08/15/2020 Maturity 10/01/2020 04/15/2021
7.391% YTM 7.67% 8.245%
4.447 Modified Duration 4.259 4.596
0.243 Convexity 0.231 0.269
$106.50 Price $101.28 $96.25
BB- Rating (S&P) B+ B
Callable Optionality Callable Callable
Financials Sector Financials Financials
- Gain/Loss -124 -380
Source of Swap Profit
BPS Pick-up = Interest Rate + Credit Risk + Sector Risk + Optionality Risk + Mispricing
In this section, I examine the four different characteristics that comprise the 318 basis point pick-up the
portfolio would see from executing the swap. I first calculate the interest rate pick-up, and determined that
162 of the basis points pick-up come from increasing the portfolio duration from ArcelorMittal’s 3.387 to
First Data’s 4.273. I then performed a credit risk pick up test to calculate how much of the pick-up could
be attributed to decreasing a credit rating, finding that 164 basis points can be attributed to this. The sector
pick-up test indicated that switching into the financials sector from the materials sector would only gain 6
basis points adding to the overall pick-up. I then calculated the basis points gained from increasing our
optionality risk. The test revealed a pickup of 278 basis points due to our switch from straight to callable.
Lastly, I found that the bond is mispriced undervalued by 292 basis points, only 52 basis points different
in comparison to my other undervaluation calculation.
Interest Rate Pick-up: + 162
I found the first source of swap profit, interest rate pick-up, by finding another bond with extremely
similar characteristics of ArcelorMittal, but with a similar duration of First Data. By performing a horizon
return analysis between these two bonds with my most likely scenario of no change in basis points for
MTNA and a decrease of 50 basis points for FDC, the test singles out how much pick-up can be attributed
to the interest rate risk, seeing as everything else is held constant. After finding 2 comparable bonds and
performing the test, the return pick-up from the swap resulted in a positive gain of 162 basis points. This
is a beneficial pickup seeing as I have risen the duration from ArcelorMittal’s 3.387 to First Data’s 4.273.
I chose to raise the duration because I believe treasury rates will slightly decrease by 25 basis points and
believe an increased exposure to interest rates will help to increase our return.
Sell Candidate Buy Candidates
ArcelorMittal Company Suzano Trading Titan Global
9.85% Coupon 5.875% 4.25%
06/01/2019 Maturity 01/23/2021 07/01/2019
4.944% YTM 5.593% 5.198%
3.387 Modified Duration 4.837 3.731
0.146 Convexity 0.282 0.183
$121.50 Price $100.50 $94.50
BB Rating (S&P) BB BB
Straight Optionality Straight Straight
Materials Sector Materials Materials
- Basis Point Pick-up 162
Credit Risk Pick-up: + 164
Our swap profit is also impacted by credit risk, and given that ArcelorMittal has a rating of BB while
First Data has a rating of BB-, it is expected that some of our basis point pick-up comes from taking on
additional credit risk. In order to calculate how much of the basis point pickup can be attributed to the
additional credit risk I found 2 bonds similar to ArcelorMittal but with the same credit rating as First
Data. I then performed a horizon return analysis between these two bonds with my most likely scenario
of no change in basis points for MTNA and a decrease of 50 basis points for FDC, singling out how much
pick-up can be attributed to the credit risk while holding everything else constant. After performing the
test, I observed that 164 out of the 318 basis point pick-up were due to an increase in credit risk.
Sell Candidate Buy Candidate
ArcelorMittal Company Greif Inc United States
Steel Corp
US USD BB
Index
9.85% Coupon 7.75% 7.375% 5.92%
06/01/2019 Maturity 08/01/2019 04/01/2020 N/A
4.944% YTM 4.302% 7.194% 4.79%
3.387 Modified Duration 3.686 3.991 5.15
0.146 Convexity 0.167 0.201 0.06
$121.50 Price $113.25 $100.50 $103.98
BB Rating (S&P) BB- BB- BB
Straight Optionality Straight Straight N/A
Materials Sector Materials Materials N/A
- Basis Point Pick-up 164
Sector Pick-up: + 6
The next source of swap profit is derived from the changing of sectors, and in order to calculate this I
compared our ArcelorMittal bond with a new bond with similar characteristics except for the sector being
the same as First Data. I then performed a horizon return analysis between these two bonds with my most
likely scenario of no change in basis points for MTNA and a decrease of 50 basis points for FDC,
singling out how much pick-up can be attributed to switching from the materials sector to the financials
sector, seeing as everything else was held constant. After performing the test, I calculated that switching
into the financials sector from the materials sector would gain us 6 basis points. I find that the results of
this test are justifiable due to the fact the spread is currently almost 0. If my estimates that the spread will
continue to stay so narrow throughout our holding period, this would serve beneficial because we will be
reducing our exposure to the volatile oil industry exposure we currently have with ArcelorMittal in our
portfolio.
Sell Candidate Buy Candidate
ArcelorMittal Company Navient Corp
9.85% Coupon 5.5%
06/01/2019 Maturity 01/15/2019
4.944% YTM 4.484%
3.387 Modified Duration 3.368
0.146 Convexity 0.137
$121.50 Price $103.25
BB Rating (S&P) BB
Straight Optionality Straight
Materials Sector Financials
- Basis Point Pick-up 6
Optionality: + 278
To test the pickup gained by altering our optionality from straight to callable I found a bond with very
similar characteristics to ArcelorMittal but was callable. By doing this I could isolate an estimated pickup
that would add to our pickup should we choose to swap into First Data. I performed a horizon analysis
using my most likely scenario, no change in basis points for MTNA and a decrease of 50 basis points for
FDC, in order to find the pickup. I concluded that by switching into a callable bond we will receive 278
basis points of pickup. This is understandable as bondholders demand a higher premium because by
taking on the optionality they expose themselves to callable risk.
Sell Candidate Buy Candidate
ArcelorMittal Company Neenah Paper USG Corp Evraz Inc
9.85% Coupon 5.25% 5.875% 7.5%
06/01/2019 Maturity 05/15/2021 11/01/2021 11/15/2019
4.944% YTM 5.08% 4.070% 8.154%
3.387 Modified Duration 3.601 1.477 3.724
0.146 Convexity 0.157 0.030 0.174
$121.50 Price $100.12 $106.25 $97.25
BB Rating (S&P) BB BB BB
Straight Optionality Callable Callable Callable
Materials Sector Materials Materials Materials
- Basis Point Pick-up 278
Mispricing: -292
The final source of return is mispricing. I calculated the mispricing by subtracting the sources of return
from the 318 basis points pickup in my most probable scenario. We can see that by this method the bond
is undervalued by 292 basis points, only 52 basis points off of my previous calculation showing accuracy
of my result. When determining the fair value I found that both bonds are undervalued, however, First
Data is significantly more undervalued making the mispricing attractive as I believe the yield will
decrease.
Mispricing Summary
Below is a summary of the above analysis that shows each of the four sources:
Sources of Return Summary
Interest Rate Pickup 162
Credit Risk Pickup 164
Sector Risk Pickup 6
Optionality Pickup 278
Mispricing -292
Total 318
Credit Analysis
The source of swap profit tests serve a beneficial tool when analyzing where the return actually comes
from, but when considering a swap into First Data, it is essential to also examine the balance sheet and
cash flow statements of the company. With the reaffirmation of First Data’s BB- credit rating in June and
increased outlook from stable to positive, First Data’s financial health appears to be secured. While their
financial ratios such as debt/equity and current ratio are lagging behind the industry, First Data is taking
proactive steps to reduce their debt and increase their financial stability. During 2014, First Data made
significant changes to their capital structure which included the parent company, First Data Holdings,
completing a $3.5 billion private equity placement. $2.5 billion of the net proceeds were contributed as a
capital contribution and used to strengthen the balance sheet by paying down debt. Additionally, $5.7
billion of the 2018 term loans were repriced. As a result, First Data now has a weighted average interest
rate of 7.4% across the debt and as of December 31, 2014, approximately 80% of the debt is at a fixed
rate, providing a measure of protection if interest rates do indeed begin to rise. Management believes that
these actions will help to reduce annual cash interest payments by approximately $228 million.9 I believe
this move to change their capital structure has allowed First Data to take the correct step towards reducing
their large debt as seen from their recent reduction in debt. A majority of their debt comes from the
leveraged buyout performed by Kohlberg Kravis for $25.6 billion in 2007 in which they were taken over
and privatized. A small portion of their total debt has come from debt offerings. Credit risk is prevalent
as we will be decreasing our rating from BB to BB-. The historical spread between the two ratings is
approximately 50-75 basis points. I believe this is the correct move for our portfolio since the credit
spread is currently narrowing and I do not believe will widen during our workout period. First Data has
positioned itself to continue its ability to satisfy debt obligations and continue its business without the fear
of defaulting on any debt satisfying the bondholders.
ArcelorMittal Metals and
Mining First Data
Financial
Services
Total Debt 19.8 billion - 20.9 billion -
Debt/Equity .47 .74 11.92 2.06
Coverage Ratio .67 1.11 1.75 89.6
Current Ratio 1.33 1.81 1.04 1.37
ROA -0.92% 2.16% 0.03% 0.7%
Profit Margin -1.37% 4.07% 14.48% 9.4%
Conclusion
Swapping our position in ArcelorMittal for First Data will greatly benefit our portfolio by switching into
a slightly less risky sector, taking credit risk with the assumption that the credit spread will continue to
narrow, and that interest rates will slightly decrease by approximately 25 basis points. By determining the
relationship between First Data and the S&P 500 as well as the Treasury the most likely scenario that will
occur during our workout period is for First Data’s yield to decrease by 50 basis points and
ArcelorMittal’s yield to stay at its current level. This scenario would generate 318 basis points ($43,008)
of profit and on average the stress test returned an average of 160 basis points ($19,854) with a positive
return coming from 72% of scenarios. The profit from my most probable scenario can be broken down
into five sources: interest rate pick-up (162 bps), sector pick-up (6 bps), credit pick-up (164 bps),
optionality pick-up (278 bps), and mispricing (-292 bps). I strongly recommend the Roland George
Investments Program swap our position in ArcelorMittal for First Data Corporation.
9 http://services.corporate-ir.net/SEC.Enhanced/SecCapsule.aspx?c=111215&fid=9960628