Buy Candidate Analysis
JPMorgan Chase & Co. provides global financial services and retail banking. The Company provides services such as investment banking, treasury and securities services, asset management, private banking, card member services, commercial banking, and home finance. JP Morgan Chase serves business enterprises, institutions, and individuals. Boasting some $2.5 trillion in assets, JPMorgan Chase is the largest bank holding company in the US and among the largest half-dozen in the world. With some 5,250 branches in about two dozen states, it is among the nation’s top mortgage lenders and credit card issuers (it holds some $141 billion in credit card loans). Active in 60 countries, the bank also boasts formidable investment banking and asset management operations through its subsidiaries JPMorgan Private Bank and institutional investment manager JPMorgan Asset Management, which has $2.5 trillion in assets under supervision. The company can trace its history back to the Bank of Manhattan Company, founded in 1799. The company’s operations are divided into four major business segments (and a corporate segment): Consumer & Community Banking, Corporate & Investment Bank, Commercial Banking, and Asset & Wealth Management. The company makes around half its money from interest.
In order to determine the benefit of swapping the PIMCO Total Return for JP Morgan, several variables must be examined and analyzed. The first variable to be examined is interest rates. From there, a forecast will be developed over the next 12-18 months. Additional economic indicators, political factors, future monetary and fiscal policies will also be examined to aid in the forecast. Then, the forecast will show the benefits of swapping PIMCO for JP Morgan. Comparisons between the historical performance and yields of different corporate bond ratings and sectors will be made to help explain the basis point pick up. Comparisons between the historical yields of PIMCO and JP Morgan will also be made to show how they align with the interest rate forecasts set in this report. An interest rate stress test with 122 scenarios is run to show the potential profit and loss from each scenario. Additionally, a credit stress test was run to the show effects of a rating upgrade during the workout period. Under the most likely scenario, the Roland George Fixed Income Portfolio would pick up 492 basis points from the swap. This basis point pick-up is broken down into interest rate pick-up, credit risk pick-up, sector pick-up, and bond mispricing pick-up.
When it comes of analyzing interest rate for the next 12 month, I assume that the main driver of increasing interest rate will be the ability of the government to cut the taxes in 2018. We know that the Republicans are committed to comprehensive tax reform, but there are policy differences among their plans. House Republicans released a tax reform blueprint last year, and they are currently writing a full bill based on it. Trump released his own tax reform platform during the campaign. The House GOP blueprint will likely be the starting point. This plan would generally repeal targeted tax benefits in exchange for rate cuts, but unlike past reform efforts it also seeks to make structural changes. The idea is to convert the business income tax system to a more cash flow-based system that mimics the economic impact of a consumption tax like a value-added tax for the economy.
Therefore, While Republican leaders and the White House want to complete the overhaul by the end of the year, Wall Street and political analysts think it’s likelier that a bill could pass by early 2018. On top of that The Senate Budget Committee unveiled a 2018 budget blueprint on September 28th that would open the door for a $1.5 trillion tax cut.
Knowing that, the majority of U.S. economists predict that President Donald Trump and Congress will successfully pass tax cuts by November 2018, on schedule for the congressional elections. The administration has promised that the tax plan, which includes cutting individual and corporate tax rates and reforming the tax code, will raise GDP growth in a range from 3 to 4 percent. In this sense, I believe that in 2018 there will be a lot of demand for capital for new ideas and expansion, and consumers will be willing to borrow because they are confident about the future, and interest rate will rise accordingly by 55 bp.
Then, The Fed, which has raised rates twice this year, has said it expects to raise rates one more time in 2017. Doing so, it still sees the federal funds rate at 1.4 percent by the end of 2017, unchanged from its June forecast. It also maintained its 2018 projection, saying it sees the benchmark rate at 2.1 percent, but lowered its 2019 outlook from its June projection. It now expects the benchmark rate to be 2.7 percent by the end of 2019, instead of the 2.9 percent it previously projected. This outlook on the increase of the fed fund rate in 2018 is a positive signal of a future strong economy for the next twelve month. Using the same argument as earlier, I believe that the interest rate will move in the same direction as the fed fund rates. However, because the lowered their projection of 2019, I certainly believe that the economy will not be as good as predicted 4 months from now. In this sense, using this argument, I believe that the interest rate will rise by 30 bp.
Moreover, the central bank sees inflation running close enough to its 2% target in 2018 to indicate that it should forge ahead with its plan to increase interest rates to a more normal range, after keeping them extraordinarily low during the years following the Great Recession. Today, inflation rate is 1.7, and is expected to increase by 0.3 next year. Historically, interest rates and inflation move together, and interest rates are more volatile than inflation. In this sense, I assume that interest rate will move 3 times more than inflation so it will move by 45 basis points.
However, we all know that the rising of geopolitical tensions, domestic political discord, and shocks arising from weak governance and corruption can all weigh on economic activity. In this sense, we got to take in consideration that the US economy could face geopolitical risks from the increasingly hostile statements by U.S. President Donald Trump and North Korean leader Kim Jong Un in recent weeks raising fears of a miscalculation that could lead to war, particularly since Pyongyang conducted its sixth and most powerful nuclear test on Sept. 3. This risk is relatively low, but it has to be taken in consideration that it could happen. In such a disaster, the entire market would crash and I believe that interest rate will decrease by 105 bp.
To conclude, some upcoming events in 2018 are more likely to happen than others. Therefore, I calculated a weighted average of all my assumption using the following table:
In conclusion, I believe the rates will rise 30 basis points to 2,61% throughout the workout period.
With the United States facing possible increased GDP growth as well as a healthy bump in inflation, interest rates are very likely to increase in 2017 and 2018. Operating under the assumption that my forecast is correct, swapping PIMCO with JP Morgan will be a beneficial move that will help maximize total returns of the portfolio and protect it from adverse interest rate moves.
JP Morgan is an American multinational investment banking and financial services company. Any bank in the United States would benefit from an interest rate increase. When interest rates rise, the yield of banks bonds decrease, furthermore increasing the price of the bond. The reason for this is that banking institutions thrive off interest rates. The higher the interest rates are, the more money they collect from interest. For banks, this is the best thing that can happen to them, raising interest rates. With my prediction of interest rates increasing over the next 12-18 months, getting into JP Morgan is a smart and safe move.
Not only is it beneficial to get into JP Morgan for the future interest rate hike, but overall JP Morgan is a stable pick. The Consumer & Community Banking business comprises the entirety of the company’s consumer business and accounts for 45% of revenue. It offers consumer and business banking (including Chase Wealth Management), mortgage banking, credit cards, auto loans and leases, and student loans. The segment’s touch points include bank branches, ATMs, online, mobile, and telephone. JPMorgan’s other three segments all fall under the wholesale banking category, and are active in a vast number of areas such as investment banking, treasury services, fixed income and equity markets, market making, asset management, and wealth management, among other things. Corporate & Investment Banking brings in some 35% of total revenue, Asset & Wealth Management 12%, and Commercial Banking 7%.
In fiscal 2016 the company recorded respectable revenue growth of 5%, coming in at $105.5 billion. Interest on loans accounted for the majority of growth, climbing $3.5 billion. Non-interest revenue slipped 1% to $49.5 billion as increases in principal transactions and other items were displaced by falls in asset management commission and card income.
JPMorgan is in the process of stepping back from student loan debt Student debt is the second most common form of personal debt, having climbed quickly from fourth in the years following the 2008 financial crisis. But with wages stagnant, living costs up, and tuition fees ever rising, the debt held by embattled grads is looking increasingly insecure. JPMorgan ceased student loan issuances as long ago as 2013 and in 2017 sold off $6.9 billion of loan debt to Navient Corp, the US’s largest student loan servicer, to reduce its position further.
PIMCO Total Return invests primarily in U.S. government-related and mortgage bonds, with more than 80% of its portfolio in those two categories. Investment-grade corporate bonds, municipal bonds, and emerging market bonds make up most of the remainder of PIMCO Total Return’s exposure. The fund also has a small position in high-yield junk bonds. More than half of PIMCO Total Return’s holdings have a maturity of less than five years, and long-term debt of 10 years or more makes up less than a quarter of its total assets. With an average maturity of 7.7 years and an effective duration of 6.0 years, the fund has modest exposure to interest rate movements.
The PIMCO is a diversified portfolio of high quality bonds that is actively managed, seeking current income and long-term capital appreciation, consistent with prudent investment management. PIMCO invests primarily in investment grade debt securities, and discloses all portfolio holdings on a daily basis. The Fund will seek to maintain a consistent level of dividend income, and generally seeks to manage capital gain distributions. However, there can be no assurance that a change in market conditions or other factors will not result in a significant change in the Fund’s distribution rate or that the rate will be sustainable in the future. With a primary benchmark of the Barclays U.S. Aggregate Index, the fund offers a core bond strategy that is designed to capitalize on opportunities across multiple sectors of the fixed income market.
I conducted a proportionality regression between the 10 Year Treasury Yield and JP Morgan Yield. Then,
I conducted regression analysis comparing the historical changes of the GDP Growth and 10 Year Treasury Yield with the BBB corporate bond yield, which is an accurate comparison of the PIMCO Total Return Yield. The results are the following:
JP Morgan Regression
Since it first was issued on 5/13/2016, JP Morgan Bond is considered as new. When I conducted my regression analysis, there were not enough data to find a significant correlation between the buying candidate bond and the US 10 YR Treasury. However, this bond faced the Trump’s election in November 7th, and can be compared to the huge increase in interest rate that the US Treasury had between October and June. Indeed, interest rate went up from 1.75 to 2.34 and stabilized after that. In the same time, JP Morgan bond lost 30 bp from 3.95 on October 20th to 3.65 on June 22nd. In this sense, I used a proportionality rule to show that JP Morgan and the interest rate are -0.50 correlated. So, in this case, for the next 12 months, JP Morgan Yield will decrease by:
Yield Change in JP Morgan = Interest rate change x -0.50
= – 15 Bp.
Yield Change in PIMCO = (Interest rate change x 10YR coefficient) + (SP 500 Estimate – SP 500 Actual) * SP500 Coefficient)
= 2.11 x 0.30 + ((10% – 15%) / 260 x 0.06)
= 62 bp
Return on Swap:
JP Morgan Return = 4.29 %
PIMCO Return = 3.67 – (0.62 x 5.55) = 0.23 %
Bp Pickup = 406 bp
Based on my analysis, I expect the SP 500 return to a positive 10 % throughout the workout period. This is 5 percent less than last year. Similarly, I expect the 10-year yield to increase 30 basis points. With these estimates, the regression analysis forecasted a 15-basis point decrease for JP Morgan and a 62-basis point increase in PIMCO. As shown below, if the aforementioned scenario were to play out, the portfolio would see a pickup of 406 bp.
Fair Value for JP Morgan
To calculate the fair value of JP Morgan’s bond, I found three similar bonds to that of JP Morgan. All comparison bonds had close yields, durations, coupons, and optionality. They are all in financial sector as well. From there, I calculated the average yield of the comparable bonds to calculate the spread. Multiplying that by the negative of JP Morgan’s duration gives an estimate of a 22–basis point mispricing.
Average Yield = 3.75%
Spread = 4 bps
Mispricing = -Duration x bps spread
Mispricing = -5.58 x 4
Mispricing = 22 basis points
Then, I compared the JP Morgan bond with other bonds in the same sector with the same rating and modified duration. I found that JP Morgan bond is mispriced by 53 basis points.
Finally, I used the Bloomberg Fair Value for the Credit mispricing. This function gave me a fair value of 19 basis point.
If I average the three method of mispricing, I found a fair value of JP Morgan bonds of 31 basis point undervalued
Interest Rate Stress Test
Interest rates are one of the key determinants in the price of a bond. To analyze the impact of changing rates, I performed a stress test showing the spreads as well as the net profit/loss and basis point pickup of the swap under numerous conditions. In total, 122 scenarios were run that test the results of basis point movements from 30 basis points to 150 basis points in each direction. Included is the predicted outcome derived from the regression analysis discussed earlier. The results of the stress test can be found in the table below:
|JPM||PIMCO||Spread||JPM||PIMCO YTM||Net $P/L||BP Pickup|
After reviewing the results of the stress test, a positive basis point pickup occurs in 41 % of the depicted scenarios. Under the closest most anticipated scenario, JP Morgan’s bond yield would decrease 30 basis points while PIMCO’s would increase by 30 basis points. This would result in a pickup of 501 basis points and a swap profit of $5,202. The range of values produced by the stress test range from a pickup loss of -2187 bp (JP Morgan +150 bps, PIMCO -150 bps) at the low end and a pickup profit of 2438 (JPM -150 bps, PIMCO +150 bps).
Credit Rating Stress Test:
To examine the effects of a credit downgrade upgrade after purchase, I looked at a comparable financial bond with a BBB and A- rating. The table below shows the magnitude of the loss or gain the portfolio could expect to incur if JP Morgan were to experience and credit downgrade or upgrade. However, JP Morgan is in excellent financial standing since they are now really stable for in their business for the past few years. Regardless, I ran a simulated swap moving out of a BBB+ into a BBB. The result was a loss of 90 basis points
|JP Morgan||Company||Bank of America|
|N/A||Basis Point Pick-up||-90|
Below is the credit spread between the United States BBB+ and BBB financial Composite Indices.
Source of Profit:
The regression analysis conducted earlier showed a predicted swap profit of 320 basis points. This profit can be broken down into five sources: interest rate pickup, credit rating pickup, sector pickup, optionality pickup, and basic bond mispricing. In this case, Rating can be ignored as PIMCO and JP Morgan are BBB+.
Interest Rate Pickup: + 450 bp
To calculate the contribution of interest rate risk to our basis point pickup, I found five different bonds in the top 5 sector of the PIMCO with a similar coupon rate, credit rating, and optionality to that of PIMCO. However, the durations were longer, similar to JP Morgan. Then, I examined the results of swapping PIMCO with those bonds under my predicted interest rate movements. The swap resulted in an average 450 basis point pick-up.
|PIMCO||Company||UBS||AT&T||Corning Inc.||Saci Falabella||AIG Life|
|All||Sector||Bank||Wireless Telecom||Technology||Consumer Discretionary||Insurance|
Interest rate Pick up
456 – (367 – (62 * (6.08+5.55)/2)
= + 450 bp.
Sector Risk Pickup: + 5 bp
To identify how much we would lose from moving up in sector, I simulated swapping PIMCO with three similar bonds that were all financial. This resulted in an average gain of 10 basis points.
|PIMCO||Company||Morgan Stanley||UBS AG||CITIGROUP|
Sector Pick up
372 – 367 = 5 bp
Optionality Pickup: – 35 bp
To identify how much we would lose from moving from PIMCO to a BULLET bond, I first compare how much we would lose from swapping a regular financial callable bond to JP Morgan which is BULLET.
|Buy Candidate||Company||Sell Candidate|
|JP Morgan||CUSIP||Bank of America|
Using the HZ1 function on Bloomberg, swapping a JP Morgan Bond from a similar callable bond, would give a negative return of 105 bp. PIMCO is an ETF that represents the whole market with a BBB+ rating average. According to Bloomberg, out of the 9000 BBB+ active bond in the market, 3000 are callable, which gives a ratio of 1/3. I assume that by doing the trade between PIMCO and I would only pick up 1/3 of the total return. Therefore, the optional pick up is: 105 x 0.33 = 35 bp.
Mispricing Pick Up:
|Credit risk||Sector risk||Optionality risk||Mispricing||Total|
On September 29th, Fitch Ratings has affirmed JPMorgan Chase & Co.’s (JPM) long-term Issuer Default Rating (IDR) at ‘A+’ and short-term IDR at ‘F1’. Fitch has also affirmed JPM’s Viability Rating (VR) at ‘a+’. The Rating Outlook is Stable. According to Moody’s’ “JPM’s ratings affirmation reflects the strong underlying earnings capacity of the bank, strong funding flexibility, given its deposit raising capabilities and uninterrupted access to the global capital markets through a variety of economic cycles, strong liquidity profile, solid capital ratios, and experienced management team, which has deep bench strength.”
|Long-term issuer rating||A3||A-||A+|
|Short-term issuer rating||P-2||A-2||F1|
Indeed, JPMorgan has become the largest bank in the United States, with about $1.4 trillion in deposits. Over $400 billion of these funds bear no interest costs whatsoever. Within payments, JPMorgan is the largest issuer of credit cards in the U.S. and the second-largest acquirer. The company’s investment bank is the leading global generator of fees, and the company’s fixed-income, commodities, and currency trading operations are the largest in the world. Therefore, I believe that the company is too big to fail for the next years.
On top of that their balance sheet show that JPMorgan Chase will enter 2018 in a strong position. Indeed, the company’s balance sheet is strong, with a common equity Tier 1 ratio well over 12% and more than half a trillion dollars in high-quality liquid assets. Credit quality remains pristine, and performance is strong across the company’s lines of business.
Since JP Morgan is an old bank, their statement show that the company as no capital expenditure for at least the past ten years. This is understandable because JP Morgan doesn’t need to acquire any new industrial building or equipment. Therefore, their free cash flow is exactly equal to their operating expenses since 1990. On the graph the operating cash flow and free cash are then represented by the same black line. Looking more in details to the graph, we see that the investing and the financing part balance out at any point in time, which means that over the years JP Morgan has been able to finance their investment and repay their debt effectively. For example, on quarter 2 of the year 2015 the company had to repay a large amount of debt. To do so, they sold some assets, and got some cash from investing. More in general, we can see a repetitive pattern between financing cash flow and investing cash flow. Historically, the two curves have been inverse related and will be the next years. In fact their management has not change and their policy on the cash flow management remains the same.
Looking into the future, this table gives us a good forecast of the possible default risk of the company. In fact, for the next year they are able cover their interest twice over, and their current assets are 235% of their current liabilities. They aren’t over leveraged, and they have significantly more total assets than debt. Therefore JPM shows no sign of defaulting, and investors’ should be confident in the repayment of their obligations.
|2.10||Debt to Equity||2.0||1.64||1.68||1.77|
|.21||Debt to Assets||.18||.196||.21||.19|
To conclude, swapping PIMCO’s bond for JP Morgan’s bond would benefit the portfolio. With the forecast of interest rate going up for next year, the spread between the two yields will increase. Indeed, PIMCO is representing the whole market so its overall yield will move upward with the interest rate. On the other side, to compensate the increase in interest rate, I choose to go into the financial sector because banks are well known to be negative correlated to interest rate, so I predict the yield of JP Morgan will go down. On top of that, JPMorgan Chase dominates Wall Street investment banking. It’s also the largest US bank by assets and market capitalization. In this sense, they will have the cash to pay back all their bonds issue in the next years. Then, since their bonds have a really small risk of defaulting in the next years, JP Morgan is a safe company to invest in for next holding period. Finally, the swap will earn a potential 406 basis point pickup if JP Morgan’s yield decreases by an estimated 15 basis point and PIMCO increases by the 62 as I am projecting. Therefore, I recommend the Roland George Investments Program swap its position in PIMCO Bond for JP Morgan Bond