Roland George Investments Program
Bond Swap Recommendation
Buy Candidate Analysis
The Kraft Heinz Company is a producer of food products. The company distributes dairy products, flavored milk powders, sauces, and other products. The Kraft Heinz Company is one of the largest food and beverage companies in the world. In addition to its two namesakes, the company’s portfolio of iconic brands (four of them billion-dollar brands) include such names as Cracker Barrel, Oscar Meyer, Capri Sun, Ore-Ida, Kool-Aid, Jell-O, Planters, Philadelphia, Lunchables, Maxwell House, and Velveeta. Kraft Heinz has employees in more than 45 countries and sells its products in some 190 countries. The company was formed in mid-2015 when Heinz and Kraft merged. In early 2017, Kraft Heinz withdrew a $143 billion bid for consumer products giant Unilever after Unilever’s management and shareholders resisted. Kraft Heinz’s operations are organized across some half a dozen specific product categories. Its largest segments are condiments and sauces (about a quarter of sales) and cheese and dairy (about 20%). Other segments include meats and seafood and ambient, or shelf-stable, meals (both at about 10%); as well as frozen and chilled meals, refreshment beverages, and coffee. Unlike many of its major competitors, Kraft Heinz counts the US as its largest market by far, accounting for about 70% of total revenue. Canada and Europe together contribute more than 15%, with the remaining revenue coming from Latin America, the Asia-Pacific region, the Middle East, and Africa. The company’s bond currently has a BBB- rating from S&P.
In order to determine the potential benefit of swapping $100,000 out of the PIMCO Investment Grade ETF Bond for Kraft Heinz Food Co., quite a few variables must be observed and analyzed. The primary variable to be observed is interest rates. From there, a forecast will be developed over the following 12-18 months. Supplementary economic indicators, political factors, and future monetary and fiscal policies will also be observed to help in the forecast. Then, the forecast will show the benefits of swapping $100,000 out of the PIMCO Investment Grade ETF Bond for Kraft Heinz Food Co. 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 Kraft Heinz will also be made to show how they align with the interest rate forecasts set in this report. An interest rate stress test with 50 scenarios is run to show the potential profit and loss from each scenario. Additionally, a credit stress test was run to show the effects of a rating upgrade during the workout period. Under the most likely scenario, the Roland George Fixed Income Portfolio would pick up 203 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.
Interest Rate Level Forecast
Bonds typically offer more moderate returns but are also less risky than equity investments. With that said, investors usually look to move towards bonds when they want a less risky portfolio after predicting the future economic environment. Government bonds are considered extremely safe, mainly because the U.S have never defaulted on their debt, making them a default risk-free investment. Consequently, when there is a higher risk in corporate bonds, demand for Treasury bonds increase, causing the yield to fall. Additionally, in times of geopolitical tensions, Treasury bonds are highly affected because they are government based securities. Therefore, since the 10-year Treasury notes serve as a benchmark for the fixed income market, they tend to affect the rate of every other bond in some way. During the week Trump was elected president; 10-year yields increased 40 basis points from 1.83% to 2.23%. Since then, the 10-year rate has averaged 2.35% and is currently at 2.3%. At the same time, the Fed Reserve raised rates an additional 50 basis points and the S&P has a year to date return of 14.40%.
There is a variety of different factors that could affect interest rates level on the horizon. In order to have a more accurate prediction of future rate level I will take into account four different economic drivers and how likely they are to change throughout the next 12-18 months.
First, the Federal Reserve already announced that they plan to raise rates 4-5 times in 2018; however, the 10 Year note (Benchmark) has already proven that it does not vary with the Fed Rate on a 1 by 1 basis. For example, on the most recent Fed hike, it was predicted that the 10 Year Treasury Note would have also raised, however, the market did not react as expected, and the Treasury yield stays near the same level after the Fed raised rates. Moreover, the 10-Year Treasury note has risen from 2.23 to 2.3 since the Federal Reserve announced the planned rate hikes for 2018. With that said, interest rates movement can be said to be completely determined by the market, and the Fed can only propose a move in payments in trying to slowing the economy down with a raise in Fed rates. Accordingly, I do not see interest rates moving as much as Fed rates over the next year. I predict that the 10-year note will most likely move about one third of the rate the Fed raises. On that basis, if the Fed maintain its current plan of raising the rates 4 times in 2018, I predict a 30 basis point pick up in the 10-Year Treasury note.
Second, inflation will also have a minor effect on bond yields; however the extremely low rates we are seeing are of little to no consequence. With inflation at extremely low levels, the yield price will likely not change much. A forthcoming possibility of a few basis point shift in inflation rates will have a diminishing effect on bond yields, and forecasting inflation rates should be done by those seeking longer-term investments. Our 12-18 month workout period means we need not worry ourselves with the possible bp adjustments in inflation rates. Since the economy is near full employment, the Fed is adjusting rates to keep inflation in check. Even without the Fed’s immediate intervention, inflation is unlikely to skyrocket. With the Fed adjusting rates to further control inflation, the current rate of about 2% will likely remain within the same range for the upcoming year.
Third, with the government proposed tax cut likely happening in 2018, interest rates will likely be affected. The Republican tax reform plan will likely push up growth and cause the Fed to kike interest rates faster than it had planned. With the majority of U.S economists predicting that President Trump and Congress will successfully approve the new tax reform by November of 2018, which consists of cutting individual and corporate taxes, the plan would boost economic growth by 0.4 percentage points by the end of 2018. Under a scaled-back scenario, GDP would get a 0.2 percentage point push, according to Deutsche bank. In this case, 2018 will be a year with 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. Consequently, I predict interest rates to rise an additional 50 basis points with the new tax reform probable to happen in 2018.
Lastly, rising geopolitical tensions, domestic political discord, and shocks arising from weak governance and corruption can affect future economic activity and have a negative impact on interest rate level. With tensions arising between Trump and North Korea leader Kim Jong Un, increased fear from the population can cause investors to think twice before investing in the fixed income and equity market, especially government based securities. If tensions continue to increase and any unexpected event were to happen, I predict that interest rates will decrease by 25 basis points.
In conclusion, after putting all my assumptions together (30 basis points coming from the Fed raising rates 4 times throughout 2018, 50 basis points with the new tax reform plan, and -25 basis points due to geopolitical tensions), I predict that the 10 Year Treasury yield will raise by 55 basis points over the next workout period.
The below graph is the US Treasury actives curve from Bloomberg. It shows the one year projected yield from Treasury securities. It varies from my predictions, but I believe it is too conservative because of past performance. However, I will weight this projection equal with my own for a 12-month prediction.
To summarize, I think the 10-year Treasury yield will increase by 55 basis points over the next workout period. I will average my prediction with the information provided by Bloomberg. The forward curve is at approximately 2.6 in one year, and my prediction puts it at 3.05 in one year. Therefore, I will use an interest rate prediction of 2.83. This is a 12 months rise of 53 basis points.
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 Kraft Heinz Food Co. will be a beneficial move that will help maximize total returns of the portfolio and protect it from adverse interest rate moves.
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 7.64 years and an effective duration of 5.55 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.
With the prediction of interest rates to continue to increase as the economy continues to grow under Trump (S&P is up 15.85% YDT), provides a great opportunity for investors to own Kraft Heinz Food bond. As consumer spending in defensive goods will likely increase due to higher rates, I predicted Kraft Heinz Yield to increase at a significantly lower rate compared to PIMCO and therefore provide a good opportunity for profit. Kraft Heinz bond has a modified duration of 7.35, compared to the 5.55 of PIMCO. Also, if we wish to maximize our Bond portfolio return we must bare additional interest rate and credit risk. With that said we will be able to pick up bps by moving from a BBB+ bond to a BBB- bond in KHC. We will continue to have a safe investment while at the same time increase our return for the portfolio. Looking at this year yield, both KHC and PIMCO have stay relatively the same and slightly decreased over this past year. However, with a higher interest environment, KHC bond yield will increase at a much lower rate as defensive stocks tend to benefit from a higher interest rate environment, therefore bringing a positive swap profit for our portfolio. My expectations of interest rates rising an additional 53 bps within the workout period signals that my bonds yield will gain an additional 56 bps, while PIMCO yield will increase by 112 bps for the same period. Therefore, our portfolio will be able to capitalize on the lower yield change of Kraft Heinz bond and earn a total return of 279 bps.
I conducted a regression analysis comparing the historical yield change in the KHC bond and the daily change in the U.S.10 year treasury rate and the S&P 500 in order to predict the future yield of Kraft Heinz food.
Kraft Heinz Co Regression
|Adjusted R Square||0.960475558|
|Coefficients||Standard Error||t Stat||P-value|
Yield Change in Kraft Heinz Co = 1.0998 * (+53bp gain 10-year) + 0.49796* ((+8%-16%)/260)
Yield Change in Kraft Heinz Co. = +56
|Adj. R Square||0.208158|
|Coefficients||Standard Error||t Stat||P-value|
Yield Change in PIMCO= 2.11 * (+53bp gain 10-year) + 0.06* ((+8%-16%)/260)
Yield Change in PIMCO = +112
PIMCO Total Return: (3.67 – (1.12 * 5.55)) = -2.55%
Kraft Heinz Total Return: = 0.24%
Portfolio Basis points pickup = 2.55% + 0.24% = 2.79% or 279 bps
Based on my analysis, I expect the S&P 500 to return a positive 8% throughout the workout period. Similarly, I expect the 10-year yield to increase 53 basis points. The regression analysis shows that Kraft Heinz bond yield will increase by 56 basis points if my expectations for the 10 year U.S. treasury rate and S&P 500 return hold true. On the other hand, PIMCO yield would increase by 112 basis points. This would result on a negative return of 255 basis points if we were to hold PIMCO instead of swapping it for Kraft Heinz. In conclusion, if the afore mentioned scenario were to play out, the portfolio would see a pickup of 279 basis points by making the proposed swap.
The proposed swap would result in a sector change as PIMCO is a Bond ETF and Kraft Heinz is in the Food & Beverage sector. Additionally, the swap will result in a move down in credit ratings from BBB+ to BBB-.
Fair Value for Kraft Heinz Food
To calculate the fair value of Kraft Heinz Food Co. bond, I used two different estimations. First, I found three similar bonds to that of KHC. All comparison bonds had similar yields, durations, coupons, and optionality. They are all in the food & beverage sector as well. From there, I calculated the average yield of the comparable bonds to calculate the spread. Multiplying that by the negative of Kraft Heinz duration gives an estimate of a 148 basis point mispricing.
Average Yield = 3.30%
Spread = 30 bps
Mispricing = -Duration x bps spread
Mispricing = -7.35 x 30
Mispricing = undervalued by 221 basis points
|Company||Kraft Heinz||TAP||Constellation Brand||Pernord Ricard SA|
I also used the Bloomberg Terminal’s Fair Value function to find the fair value for Kraft Heinz when compared to the USD US BBB- Composite Index. This resulted in a spread of -5 basis points. The spread between the bond and composite rating are graphed below
Mispricing = -Duration x bps spread
Mispricing = -7.35 x -5.0
Mispricing = overvalued by 37 basis point
The average of these two fair value metrics, -148 basis points and +37 basis points, implies that Kraft Heinz bond is undervalued by 92 basis points.
Interest Rate Stress Test
Interest rates are one of the key determinants in the price of a bond. To analyze this, I conducted multiple interest rate stress tests to determine how sensitive each bond is to interest rate change and how much bps pickup or loss we would incur on the two bonds. I went about this process by utilizing the Fixed Income Horizon Analysis found on Bloomberg. I used 122 different combinations of interest rate movement and determined the new yield of each bond, the dollar profit or loss and finally the basis point pick up or loss from the two bonds. I stressed in increments of 30 bps in each direction up to 150 basis points for each bond as well as workout date to fit into that of our investment policy statement and ran each test. The results of this interest rate stress test can be found in the table below:
|KHC||PIMCO||Spread||KHC||PIMCO YTM||Net $P/L||BP Pickup|
After reviewing the test, I found that the proposed swap produces positive basis point pick up 49% of the time when stressed under different interest rate scenarios. Under my most anticipated scenario, KHC’s YTM would increase by 56 basis points while PIMCO’s YTM would increase by 112 bps. This scenario resulted in a 279 basis point pickup or $2,439.04 profit to our portfolio The greatest basis point pick up would be 1718 bps pick up (KHC -150, PIMCO +150), while the largest lost would be -1710 bps (KHC +150, PIMCO -150). Kraft Heinz bond is a strong contender to increase our overall portfolio’s total return during the workout period given the forecasted interest rate environment.
Credit Rating Stress Test
To examine the effects of a credit downgrade after purchase, I looked at a comparable Food & Beverage bond with a BB rating. The table below shows the magnitude of the loss the portfolio could expect to incur if Kraft Heinz were to experience a credit downgrade. However, Kraft Heinz is in excellent financial standing, has a strong product diversity with leading brands, and declining that was around 4 times debt/EBITDA as of July 1, 2017. The company’s rating reflect the company’s success in achieving its financial goals since the 2015 Kraft Heinz acquisition, which includes a $1.7 Billion cost reductions, significant working capital savings, and a total of $2 billion of debt reduction by June 2017. The company could see a downgrade if it’s operating performance significantly deteriorates, or its debt/EBITDA rises to above 5.0 times. However, in my opinion, there is a very low possibility of a downgrade happening due to excellent financial position the company currently stands. Regardless, I simulated a swap by moving out of a BBB- (Kraft Heinz) into a BB (Lamb Weston) bond. The yield spread between both bonds is 35 bps, which was then multiplied by average duration of 6.3. The result was a loss of 220 basis points.
|Kraft Heinz Food Co||Company||Lamb Weston HLD|
|Food & Beverage||Sector||Food & Beverage|
|N/A||Basis Point Pick-up||-220 bps|
Below is the credit spread between the United States BBB-, BB+, and BB consumer staples bonds composite yield curves. The spread shows that the spread between both BB+ and BB consumer staples bond move very similarly and slightly tighten as the tenor increases. However, we can observe that the BBB- yield spread with the lower rating yields tend to increase throughout the years.
Sorces of Swap Profit
The regression analysis conducted earlier showed a predicted swap profit of 279 basis points. This profit can be broken down into four sources: interest rate pickup, credit rating pickup, sector pickup, optionality pickup, and basic bond mispricing. Due to the fact that PIMCO’s ETF contains bonds with different optionality’s, and that one third of the world’s BBB+ bonds are callable, the bps picked up by moving to a strictly callable bond were reduce by 66%.
Interest Rate Pickup: +271
To calculate the contribution of interest rate risk to our basis point pickup, I found five different corporate bonds in 5 different sectors in order to have a close proxy of PIMCO’s ETF. The sectors used were identified by looking into PIMCO’s vast portfolio of bonds and selected by being the largest percentage of total corporate bonds holding inside the ETF. Furthermore, the bonds used have similar rating and optionality compared to PIMCO. However, the durations were longer, similar to Kraft Heinz bond. Therefore, I examined the results of swapping PIMCO with those bonds under my predicted interest rate movements. The swap resulted in an average 271 basis point pick-up.
|Interest Rate Risk Pick-up|
|PIMCO||Company||Sammons Financial Group||Goldman Sachs||NVIDIA Corp||KIA Motors Corp||AT&T Inc.|
|All||Sectors||Insurance||Financials||Technology||Consumer Discretionary||Wireless Telecomm.|
|1.12%||Interest rate change||0.56%||0.56%||0.56%||0.56%||0.56%|
Credit Risk Pickup: +189
To identify how much we would pick up from moving up in credit ratings, I simulated swapping PIMCO with five similar bonds from different sectors that were all rated BBB-, which is Kraft’s bond rating. The average pick up was then multiplied by the average duration of all five buy candidates, resulting in a basis point pick up of 189.
|Credit Risk Pick-up|
|PIMCO||Company||Fairfax Us Inc.||Xerox Corp||Wyndham Worldwide Corp||Bharti Airtel International|
|All||Sectors||Insurance||Technology||Consumer Discretionary||Wireless Telecomm|
|0.00%||Interest rate change||0.00%||0.00%||0.00%||0.00%|
Sector Risk Pickup: -77
In order to analyze the bps pick up from moving from a bond ETF to the food and beverage sector I simulated swapping PIMCO to three different bonds in the proposed sector. The bonds selected have similar duration, optionality, and rating compared to PIMCO. The result was a basis points loss of 77, which leads to the conclusion that we would be moving to a safer sector if buying Kraft Heinz proposed bond.
|Sector Risk pick up|
|PIMCO||Company||Tyson Foods||Danone SA||Anheuser Busch|
|All||Sectors||Food & Beverage||Food & Beverage||Food & Beverage|
|0.00%||Interest rate change||0.00%||0.00%||0.00%|
|Avg. Bps loss||-77|
Optionality Risk Pickup: +121
In order to calculate optionality risk basis point pickup, I compared Kraft Heinz callable bond with an equivalent Kraft Heinz bond in terms of duration, credit rating, and sector. However, with a different optionality. Additionally, like previously mentioned in the paper, the result was reduced by 66% given that one third of the world’s BBB+ bonds are callable. This resulted in 121 basis points pickup.
|Optionality Risk pick up|
|Kraft Heinz Food Co.||Company||Kraft Heinz Food Co.|
|Food & Beverage||Sectors||Food & Beverage|
|0.00%||Interest rate change||0.00%|
Mispricing Pickup: +13
|BP Pick-up||Interest Risk||Credit Risk||Sector||Optionality||Mispricing|
Kraft Heinz bond’s optionality allows a full callback within a minimum of 30 days of notification. The next call date is 03/01/2026 at a price of $100.00. That’s the only scheduled date by the company and represents their option to redeem the security prior to maturity. The call represents a 0% premium as it is only three months prior to the maturity of the bond.
It is important to closely examine the financial stability of Kraft Heinz when considering purchasing it for our portfolio. For more than two years, Kraft Heinz’s strategic focus has centered on driving out inefficiencies from the organization by reducing its workforce, rationalizing its North American manufacturing network, and enhancing its supply chain. And the tangible gains that have resulted from these efforts are undeniable. More specifically, the firm now boasts operating margins in the high-20s, a level that towers above the mid- to high-teens generated by its packaged-food peers.
Kraft’s main advantage compared to other companies in the industry is their relatively low debt levels. With total debt of $32.4 billion, their current debt to equity ratio of 0.56 is slightly below the industry average of 0.8. Majority of the company’s debt is made up entirely of senior notes issued at different countries. The U.S. dollar notes account for majority of the company’s debt with carrying value of $27 billion dollars and are due between 2017-2046 with interest rates varying from 1.5% – 7.125. More than 30% of the company’s bonds are due after 2035.Additionally, the company’s coverage ratio of 5.42 proves that the company have the necessary earnings to cover its interest obligations.
Over the past 2 years, Kraft Heinz has maintained a debt to equity ratio between 0.43 and 0.57. This efficient management of debt levels, along with the company’s global scale and declining leverage, reflects the company current bond rating. These strengths are balanced against its senior management’s history of aggressive financial strategies including a serial pace of acquisitions and heavy cost cutting. Additionally, the company has been able to accomplish its financial goals since the 2015 Kraft Foods acquisition, which includes $1.7 billion cost reduction and a $2 billion debt reduction. According to Moody’s, Kraft’s bond rating could be upgraded if the company adopts a more conservative financial policy and debt/EBITDA is sustained below 4 times. Earlier in the year, S&P Global Ratings revised Kraft Heinz credit outlook and affirmed the BBB- rating.
|Company||Kraft Heinz||General Mills||Kellogg||Mondelez|
|Revenue||$26 billion||$15.6 billion||$13 billion||$25.9 billion|
|Profit Margin (FY 16)||14.67||10.68||6.12||6.92|
The ratings incorporate significant qualitative benefits from the company’s 51% owners, 3G Capital (3G; 24.2% ownership) and Berkshire Hathaway (Berkshire; 26.8%), who were previous owners of H.J. Heinz Company. 3G has substantially increased operating profitability and delivered acquired firms including H.J. Heinz Company (Heinz) and Restaurant Brands International, Inc. (formerly Burger King, which is now integrating the Canadian Tim Hortons chain purchased in December 2014). For example, 3G and Berkshire acquired Heinz in June 2013 and improved the company’s leverage (total debt to EBITDA) to 6.2x in 2014 from 8.9x in 2013. The improvement was driven by a 35% EBITDA increase due to lower overhead and manufacturing costs and more than $1 billion in debt repayment. As of 2Q17, Kraft Heinz has achieved $1.45 billion in savings since the merger closed in July 2015, stronger than expected, and completed approximately 70% of footprint right-sizing.
The packaged food industry is highly competitive. Kraft Heinz competes with both large national and international food and beverage companies and numerous local and regional companies. It competes with both branded products and private brands on the basis of product quality, innovation, consumer preference relevancy, brand recognition and the effectiveness of its marketing programs, distribution, shelf space, merchandising support, and price. Kraft Heinz’ current BBB- rating reflects the company’s large scale with $26 billion in annual sales, industry-leading EBITDA margins of approximately 29%, and elevated leverage after the Kraft/Heinz merger. Compared to other packaged foods companies, Kraft Heinz has the largest scale, highest EBITDA margin, and a total Debt/EBITDA leverage ratio of 4.3x as of December 2016, reflecting merger-related debt. General Mills (‘BBB+’/ Negative Outlook) had annual revenue of $15.6 billion and was levered at 2.8x total Debt/EBITDA as of December 2016. Kellogg (‘BBB’/Stable Outlook) had annual revenue of $13 billion and was levered at 3.3x total Debt/EBITDA as of December 2016. Mondelez (‘BBB’/Stable Outlook) had annual revenue of $25.9 billion and was levered at 3.7x total Debt/EBITDA as of December 2016. Kraft Heinz is expected to continue to benefit from its scale, continue to generate strong cash flow, and steadily pay down debt associated with the 2015 merger.
Kraft’s cash flow statement shows that the company constantly have positive cash from operating activities, which is used for reinvestment, payment of debt, and to grow the business. Moreover, the negative cash from investment activities throughout the past two years shows that Kraft it’s constantly growing its business by investing in new assets, replacing old equipment in order to maintain its current competitive edge. Additionally, the negative cash coming from financing activities is a positive sign for Kraft’s financial health. The negative amount suggests the business is using its cash flow from operating activities to pay dividends and pay off its outside financing. Lastly, the company’s positive free cash flow proves to be coming from Kraft’s core business operations, which allows the company to develop new products, make acquisitions, pay dividends and reduce debt without raising its liabilities.
Exposure to the Food & Beverage sector is important for a well-diversified portfolio considering the future expectations of interest rates. Kraft Heinz is one of the best possible current plays in the Food & Beverage sector. Experienced management with years of successful strategic execution allowed the company to achieve its financial goals over the past few years. Kraft’s ability to achieve cost savings while investing in product innovation may support its goal of boosting organic sales and driving wider operating margins. In contrast, PIMCO currently puts our portfolio return at risk with an expected higher interest rate environment. If all my assumptions hold true, we could see a loss of 2.55% by choosing to hold the ETF. Not only would a swap under the predicted conditions provide a positive 279 basis point pickup, but it would prevent us from losing significant return to the portfolio. Therefore, I recommend the Roland George Investments Program to swap PIMCO for the proposed Kraft Heinz bond.