Roland George Investments Program Bond Swap Recommendation Adam Frocione 3/16/2015 Buy Candidate Overview CHC Helicopter is one of the largest commercial operators of helicopters in the world based on revenue and fleet size. The company operates 234 heavy and medium sized helicopters spanning six continents. They have 70 bases which operate in roughly 30 countries. Revenue is reported in two segments: helicopter services and heli-one. Helicopter services involve the transportation of employees to offshore oil and gas customers, search and rescue, and emergency medical services. Oil and gas customers make up roughly 88% of this segment, while the latter two primarily consist of government agency contracts. Helicopter services account for 79.2% of total revenue. The second reporting segment is heli-one. It accounts for 20.8% of revenue and consists of helicopter maintenance, repair and overhaul services. These facilities are located in Norway, Poland, Canada, and the United States. The company has experienced a significant decline in sales largely attributable to a high correlation with oil. They recently retired five older models of helicopters and purchased an additional 22 to be outfitted with new technology. CHC Helicopter is and has maintained a B+ credit rating. On October 1, 2014, Moody’s upgraded the company’s outlook from stable to positive. Clayton, Dubilier, and Rice (CDR), a private equity firm, invested roughly $600 million in the company. If they can demonstrate more sustainable cash flow growth while decreasing their financial leverage below 5.5x, HELI could experience a ratings upgrade. Sell Candidate Buy Candidate MGM International Resorts Company CHC Helicopter 11.38% Coupon 9.25% 03/01/2018 Maturity 10/15/2020 4.08% YTM 10.73% 2.51 Modified Duration 4.03 0.083 Convexity 0.213 $120.50 Price $92.95 $123.35 Cost Basis - B+ Rating (S&P) B+ Straight Optionality Callable Consumer Discretionary Sector Basic Materials N/A Basis Point Pickup 384.3 4.14 Portfolio Duration 4.26
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Roland George Investments Program
Bond Swap Recommendation
Adam Frocione
3/16/2015
Buy Candidate Overview
CHC Helicopter is one of the largest commercial operators of helicopters in the world based on revenue
and fleet size. The company operates 234 heavy and medium sized helicopters spanning six continents.
They have 70 bases which operate in roughly 30 countries. Revenue is reported in two segments:
helicopter services and heli-one. Helicopter services involve the transportation of employees to offshore
oil and gas customers, search and rescue, and emergency medical services. Oil and gas customers make
up roughly 88% of this segment, while the latter two primarily consist of government agency contracts.
Helicopter services account for 79.2% of total revenue. The second reporting segment is heli-one. It
accounts for 20.8% of revenue and consists of helicopter maintenance, repair and overhaul services.
These facilities are located in Norway, Poland, Canada, and the United States. The company has
experienced a significant decline in sales largely attributable to a high correlation with oil. They recently
retired five older models of helicopters and purchased an additional 22 to be outfitted with new
technology. CHC Helicopter is and has maintained a B+ credit rating. On October 1, 2014, Moody’s
upgraded the company’s outlook from stable to positive. Clayton, Dubilier, and Rice (CDR), a private
equity firm, invested roughly $600 million in the company. If they can demonstrate more sustainable cash
flow growth while decreasing their financial leverage below 5.5x, HELI could experience a ratings
upgrade.
Sell Candidate Buy Candidate
MGM International Resorts Company CHC Helicopter
11.38% Coupon 9.25%
03/01/2018 Maturity 10/15/2020
4.08% YTM 10.73%
2.51 Modified Duration 4.03
0.083 Convexity 0.213
$120.50 Price $92.95
$123.35 Cost Basis -
B+ Rating (S&P) B+
Straight Optionality Callable
Consumer Discretionary Sector Basic Materials
N/A Basis Point Pickup 384.3
4.14 Portfolio Duration 4.26
CHC Helicopter is driven by two main factors: the price of oil and the general level of offshore
production and drilling activity. Volatility in the price of oil can cause companies to reconsider and
sometimes cut back on their capital expenditures due to decreases in their margins. The price of oil
largely sets production schedules for these companies which in turn determine how many employees and
crew changes they will need over a given period of time. HELI has experienced slowed revenue growth
over the last several quarters for three main reasons. The first being that oil prices recently plummeted
and resulted in companies scaling back their production schedules. The second reason is the company
recently purchased a 65,000 square foot hangar in Poland which will be used to do the majority of repairs
and maintenance in-house which will streamline margins and promote efficiency. Finally, HELI decided
to retire five different models ahead of schedule in order to keep up with new technology. They recently
entered into purchase agreements to add 22 new technologically advanced helicopters to their fleet. The
company has seen an increased debt to equity ratio largely in order to finance the purchases just
discussed. By upgrading their fleet of helicopters, CHC Helicopter has expanded their market share and
well positioned themselves for stability in the energy market.
Interest Rate Forecast
As evidenced by figure I below, the credit spread between US Treasury bonds and US corporate bonds
has been narrowing since 2010, indicative of improving conditions in the United States’ economy. US
gross domestic product grew at a rate of 2.4% in 2014. This figure is projected to continue growing at a
rate of 3.3% for 2015. Economic data has largely been improving with the unemployment rate in
February coming in at 5.5%, beating its forecast of 5.6%. Nonfarm payroll data from March shows that
295,000 jobs were added to the US economy. On June 19, 2013, Federal Reserve ex-chairman Ben
Bernanke suggested that if inflation followed a 2% target and the unemployment rate decreased to 6.5%
then the Federal Reserve would likely start raising interest rates. His successor, Janet Yellen, has said that
she will follow the same ideology.
The main economic indicator currently preventing a rate hike is inflation. The most recent inflation data
pegs the rate at 1.6%, inferior of the 2% target rate the Federal Reserve has hinted it will raise rates at.
The Consumer Price Index (CPI) has been marginally declining since October, experiencing -0.7%
growth in January. The CPI has recently been weighed down by falling oil prices. Projected stability to oil
prices should result in minimal change to the CPI which will keep inflation hovering around its current
level and postpone a rate hike. Since inflation has remained stable and even slightly depreciated, there is
no pressing reason to justify a rate hike. I predict that inflation will slightly rise over the course of the
year due to the eventual stability of oil prices which will result in less deflationary pressure to the CPI and
allow other sectors to bring inflation up. Interest rates will fluctuate roughly 25 basis points over the
course of the year and a rate hike will be postponed.
Figure I. Projected Yield Curve
On January 22, 2015, Mario Draghi, the president of the European Central Bank announced that they
would be launching an expanded asset purchasing program where €60 billion would be purchased per
month. This stimulus is planned to last through September 2016 and end with at least €1.1 trillion euros
on its books. The United States recently ended their quantitative easing program on October 29, 2014,
ending with $4.5 trillion in assets. The euro has seen its value depreciate against the dollar by 32.5% over
the last year. The dollar has seen significant upward momentum against the euro since August largely due
to a quickly growing US economy paired with a state of economic recovery in Europe. Further, Greece
recently began pulling themselves out of a massive hole. They recently came to an agreement with the
European Union partners to keep the country’s government solvent for the foreseeable future.
Analyzing what is going on in the Asian markets is very necessary to gauge a more complete
macroeconomic picture. China’s economy slowed down from 7.7% in 2013 to 7.4% in 2014. Gross
domestic product growth is estimated to be a slowing 6.8% for 2015. China has said before that 7%
growth is necessary to create enough jobs for China’s population. Japan is currently in the midst of a
quantitative easing program that consists of buying $80 trillion worth of bonds per year. The dollar has
largely separated itself from the yen in their currency pairing, appreciating 19.8% over the last year.
The United States’ economy is experiencing quick sustainable growth while several major economies in
the world are undergoing quantitative easing programs. The Eurozone is poised for minimal growth and
recently instituted its own program. China is seeing its growth slow down to unsustainable levels. Japan is
also in the midst of their own quantitative easing programs. The quick growth of the United States’
economy paired with a globally strengthening dollar simply does not justify a rate hike. Raising rates will
likely result in an even stronger dollar which will discourage exports.
Swap Rationale
By looking at figure II you can see that MGM is trading well below its average yield to maturity (YTM)
of 6.94%. The YTM has demonstrated profound cyclicality and typically decreases from December to
March until it spikes in June. MGM’s YTM is currently 4.08% so swapping the bond prior to an expected
yield increase in June makes sense for the portfolio. Looking at the YTM of CHC Helicopter, we see that
the average yield is 8.31%, well below its YTM today of 10.73%. From September to January YTM
rapidly increased largely due to falling oil prices. Further, MGM’s bond matures on 3/1/2018 so it is
behaving exactly as a bond of its maturity should. As oil continues to find stability it becomes apparent
from figure III that HELI’s yield is trending downward and will be more beneficial to our portfolio.
Figure II. MGM Yield Chart
Figure III. HELI Yield Chart
Indicative of strong gross domestic product projections, the United States’ economy is expected to
continue improving at a sustainable rate. I predict that the interest rate will fluctuate and ultimately
increase at year end by 25 basis points due to falling consumer price index numbers resulting in a
consistently low inflation rate largely due to deflationary pressure from falling oil prices. I decided to
increase interest rate risk because I do not believe interest rates will be interfered with by the Federal
Reserve until at least year end. MGM Resorts International has a fairly low modified duration of 2.51
when compared to that of CHC Helicopter at 4.03. By swapping these bonds total portfolio duration
increases from 4.14 to 4.26. Staying consistent with my interest rate forecast, I added 25 basis points to
the YTM of MGM Resorts International and CHC Helicopter to calculate the results for my most
probable scenario. As displayed in figure IV, by switching from MGM to HELI we will realize a 384.3
basis point pickup with a $49,839 resulting profit. This results in a wide spread of 629.8 basis points.
Figure IV. Horizon Analysis
Figure V shows that switching from consumer discretionary to the basic materials sector will benefit our
portfolio. The consumer discretionary yield spread has increased while the basic materials sector has
decreased resulting in a narrowing of the spread and room for profit by switching sectors. Companies in
the basic materials sector, specifically those with implications or a correlation to the price of oil recently
experienced their YTM’s increase significantly from September until January. Now that oil is closer to
stability and shedding some of its volatility we are seeing these yields regress back to their mean resulting
in significant gains to bond prices resulting in increased profit. Switching from consumer discretionary to
the basic materials sector will increase our YTM allowing us to realize profit from these higher but
decreasing yields.
Figure V. Sector Comparison
Fair Value for MGM International Resorts
In order to calculate a fair value for MGM International Resorts I found three comparable bonds that
demonstrated similar characteristics to MGM. I then took an average of the comparable bonds’ yields to
maturity which resulted in 4.10%. I subtracted this figure from MGM’s YTM and found a yield spread of
-0.06%. I multiplied the spread by negative MGM’s modified duration and found that the company is
overvalued by 14.2 basis points. This figure is right in line with my expectations, as I had anticipated that
MGM would be either fairly priced or overvalued. The calculated fair value for MGM Resorts
International further solidifies why I think we should swap the bond for CHC Helicopter.
Mispricing = duration * change in interest rate
Mispricing = 2.51 * -0.06%
Mispricing = 14.2 Basis Points
I also utilized the Bloomberg fair value function which compared MGM to an interpolated B value curve
and found that Bloomberg has MGM overvalued by 25.5 basis points. The fair value function plots the
yield of MGM against an interpolated yield curve of similar rating. I then derived that the spread was 25.5
basis points, signifying an overvaluation.
Company MGM International
Resorts
Standard Pacific
Corp
American
Airlines
United Continental
Holdings
Coupon 11.38% 8.38% 6.13% 6.38%
Maturity 3/1/2018 5/15/2018 7/15/2018 6/1/2018
YTM 4.04% 3.76% 4.51% 4.02%
Modified
Duration 2.51 2.743 2.97 2.85
Convexity 0.083 0.095 0.108 0.101
Price $120.50 $113.62 $104.94 $107.00
Rating B+ B+ B+ B+
Optionality Straight Straight Straight Straight
Sector Consumer
Discretionary
Consumer
Discretionary
Consumer
Discretionary
Consumer
Discretionary
Fair Value for CHC Helicopter
In order to calculate a fair value for CHC Helicopter I found three comparable bonds that demonstrated
similar characteristics to HELI. I then took an average of the comparable bonds’ yields to maturity which
resulted in 9.96%. I subtracted this figure from HELI’s YTM and found a yield spread of 0.77%. I
multiplied this spread by negative HELI’s modified duration and found that the company is undervalued
by 310.2 basis points. Similarly, this figure is right in line with my basis point pickup anticipated from
adding 25 basis points to each company’s yield of 384.3 basis points. The calculated fair value for CHC
Helicopter is very close to the pickup that would be received by swapping bonds under my most probable
scenario and further demonstrates why this recommendation would be highly beneficial to the portfolio.
Mispricing = duration * change in interest rate
Mispricing = 4.029 * 0.77%
Mispricing = 310.2 Basis Points
I also utilized the Bloomberg fair value function which compared HELI to an interpolated B value curve
and found that Bloomberg has HELI undervalued by 499.1 basis points. The fair value function plots the
yield of MGM against an interpolated yield curve of similar rating. I then derived that the spread was