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Donald R. Van Deventer, Ph.D.

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura.

# Vodafone Group PLC: A Bond Market View

04/16/2014 06:11 AM

Vodafone Group PLC(VOD) recently agreed to purchase Spanish cable operator Ono S.A. for 7 billion euros. Vodafone Group PLC itself has been a potential take-over target, with AT&T (T) announcing on January 27 that it had no intention of making a bid. Still, in these notes, we make no assumptions about the future and let the bond market facts lead us to the appropriate conclusions. Today’s study incorporates Vodafone Group PLC bond price data as of April 11, 2014 to get an institutional, bond market view of the company. We analyze the potential risk and return to bondhold

Conclusion: We believe a majority of analysts would rank Vodafone Group PLC as “investment grade,” but we also believe that this rating is in danger. The bond market shows a rare combination of relatively narrow spreads on these bonds with high default risk. We believe only two groups of investors would benefit from owning these bonds. The first group would be fund managers running a total bond market index fund like Vanguard’s total bond market fund (BND). The second group is the big data group, if and only if the big data analysts can find a way to reach different conclusions than we have after mining the more than 2 million records of information that were analyzed in this post. Investors who are not in either of these two groups have too many more attractive alternatives to consider Vodafone Group PLC bonds for their portfolio.

The Analysis
Institutional investors around the world are required to prove to their audit committees, senior management, and regulators that their investments are in fact “investment grade.” For many investors, “investment grade” is an internal definition; for many banks and insurance companies, “investment grade” is also defined by regulators. We consider whether or not a reasonable U.S. bank investor would judge Vodafone Group PLC to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. The default probabilities used are described in detail in the daily default probability analysis posted by Kamakura Corporation. The full text of the Dodd-Frank legislation as it concerns the definition of “investment grade” is summarized at the end of our analysis of Citigroup (C) bonds published December 9, 2013.

Assuming the recovery rate in the event of default would be the same on all bond issues of the same issuer, a sophisticated investor who has moved beyond legacy ratings seeks to maximize revenue per basis point of default risk from each incremental investment, subject to risk limits on macro-factor exposure on a fully default-adjusted basis. In this note, we also analyze the maturities where the credit spread/default probability ratio is highest for Vodafone Group PLC.

Term Structure of Default Probabilities
Maximizing the ratio of credit spread to matched-maturity default probabilities requires that default probabilities be available at a wide range of maturities. The graph below shows the current default probabilities for Vodafone Group PLC ranging from one month to 10 years on an annualized basis. For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The current annualized default probabilities range from 1.25% at one month to 0.79% at 1 year and 1.34% at ten years. These default probabilities are exceptionally high relative to other firms annualized in this series of notes.

Summary of Recent Bond Trading Activity

The National Association of Securities Dealers launched the TRACE (Trade Reporting and Compliance Engine) in July 2002 in order to increase price transparency in the U.S. corporate debt market. The system captures information on secondary market transactions in publicly traded securities (investment grade, high yield and convertible corporate debt) representing all over-the-counter market activity in these bonds. We used all of the 10 bond issues mentioned above in this analysis.

The graph below shows 6 different yield “curves” that are relevant to a risk and return analysis of Vodafone Group PLC bonds. These curves reflect the noise in the TRACE data, as some of the trades are small odd-lot trades. The lowest curve, in dark blue, is the yield to maturity on U.S. Treasury bonds (TLT)(TBT), interpolated from the Federal Reserve H15 statistical release for that day, which exactly matches the maturity of the traded bonds of Vodafone Group PLC. The next curve, in the lighter blue, shows the yields that would prevail if investors shared the default probability views outlined above, assumed that recovery in the event of default would be zero, and demanded no liquidity premium above and beyond the default-adjusted risk-free yield. The orange dots graph the lowest yields reported by TRACE on that day on Vodafone Group PLC bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day. The red dots show the maximum yield in each of the Vodafone Group PLC issues recorded by TRACE. The black dots and connecting black line show the yield consistent with the best fitting trade-weighted credit spread explained below.

For the first time in this series, the data shows that the credit spreads on the short end of the maturity spectrum for Vodafone Group PLC are less than the matched maturity default probability. The situation narrowly reverses for maturities of more than 10 years, but the premium over the sum of the default probability and the (approximately) risk-free U.S. Treasury yield is very narrow. This is not a good omen for fixed income investors.

The high, low and average credit spreads at each maturity are graphed below for Vodafone Group PLC. We have done nothing to smooth the data reported by TRACE, which includes both large lot and small lot bond trades. For the reader’s convenience, we fitted a cubic polynomial (in black) that explains the trade-weighted average spread as a trade-weighted function of years to maturity.

Using default probabilities in addition to credit spreads, we can analyze the number of basis points of credit spread per basis point of default risk at each maturity. For Vodafone Group PLC, the credit spread to default probability ratio generally ranges from about 0.2 to 0.55 for maturities of 5 years and under. These are extraordinarily low ratios of return to risk. For the longer maturities, the credit spread to default probability ratio falls in a range from 0.6 to 1.3 times. These ratios are also very low.

The credit spread to default probability ratios are shown in graphic form below for Vodafone Group PLC.

How far are these reward to risk ratios below “normal”? The best way to answer that question precisely is to compare them to the credit spread to default probability ratios for all fixed rate non-call senior debt issues with trading volume of more than $5 million and a maturity of at least one year on April 11. The distribution of the credit spreads on the 271 traded bonds that met these criteria on April 11 is first plotted in this histogram: The median credit spread for all 271 trades was 0.918%. The average credit spread was 1.254%. The next graph shows the wide dispersion of the credit spread to default probability ratios on those 271 April 11 trades (only ratios of 40 or less are graphed): The median credit spread to default probability ratio on those 271 trades was 6.99 and the average credit spread to default probability ratio was 9.94. Vodafone Group PLC’s credit spread to default probability ratio ranked dead last, 271 out of 271, compared to the group that traded April 11, 2014. The only other Vodafone Group PLC bond issue with more than$5 million in trading volume ranked 265th on this list of 271 trades. Here are the 20 “best trades” done April 11, 2014 that had the highest ratios of credit spread to default probability.

Credit Default Swap Analysis
For the week ended April 4, 2014 (the most recent week for which data is available), the Depository Trust & Clearing Corporation reported there were 21 trades involving \$161,181,337 in notional principal on Vodafone Group PLC, ranking the firm the 214th most actively traded reference name. The weekly number of credit default swap trades on Vodafone Group PLC since the DTCC began publicizing weekly trade volume is shown here:

The notional principal of credit default swap trading on Vodafone Group PLC over the same period is shown in this graph:

On a cumulative basis, the default probabilities for Vodafone Group PLC range from 0.79% at 1 year to 12.58% at 10 years. We give the relative rankings of the company’s default probabilities below. Compared to other firms reviewed in this series, these cumulative default probabilities rank among the highest we have seen.

Over the last decade, the 1 year and 5 year annualized default probabilities for Vodafone Group PLC have generally been volatile, with one year default probability exceeding 5.00% in 2006. The annualized 5 year default probabilities exceeded 2.50% at the same time. In recent weeks, the firm’s default probabilities have jumped substantially.

As explained earlier in this note, the firm’s default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. Over a long period of time, macro-economic factors drive the financial ratios and equity market inputs as well. If we link macro factors to the fitted default probabilities over time, we can derive the net impact of macro factors on the firm, including both their direct impact through the default probability formula and their indirect impact via changes in financial ratios and equity market inputs. The net impact of macro-economic factors driving the historical movements in the default probabilities of Vodafone Group PLC have been derived using historical data beginning in January 1990. A key assumption of such analysis, like any econometric time series study, is that the business risks of the firm being studied are relatively unchanged during this period. With that caveat, the historical analysis shows that Vodafone Group PLC default risk responds to changes in 6 risk factors among the 28 world-wide macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program, for which the results were announced in March. These macro factors explain 33.4% of the variation in the default probability of Vodafone Group PLC. The remaining variation is the estimated idiosyncratic credit risk of the firm.

Vodafone Group PLC can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the world-wide “telecommunications services” sector, Vodafone Group PLC has the following percentile ranking for its default probabilities among its 335 peers at these maturities:

1 month   93rd percentile
1 year      81st percentile
3 years    70th percentile
5 years    69th percentile
10 years  73rd percentile

These percentile rankings are among the highest that we have seen in this series of notes to date. For all longer time horizons, Vodafone Group PLC default probabilities are in or near the riskiest quartile of all sector peer group firms.

Comparison with Legacy Ratings
Taking still another view, the actual and statistically predicted credit ratings for Vodafone Group PLC both show a rating in the low end of the “investment grade” territory. The statistically predicted rating is two notches below the legacy rating, those of Moody’s (MCO) and Standard & Poor’s (MHFI). The legacy credit ratings of Vodafone Group PLC have changed just twice in the last decade.

Conclusions
Before reaching a final conclusion about the “investment grade” status of Vodafone Group PLC, we look at more market data. First, we look at Vodafone Group PLC credit spreads versus credit spreads on every bond in the “technology, media, and telecommunications” sector that traded on April 11:

Vodafone Group PLC credit spreads were near the lower end of the range for the peer group. We now look at the matched maturity default probabilities on those traded bonds for both Vodafone Group PLC and the peer group:

Consistent with the percentile rankings above, the default probabilities for Vodafone Group PLC are among the highest in the industry peer group. We note that the bonds trading heavily are generally a much better group of credits than the industry in aggregate. We now turn to the legacy “investment grade” peers. First we compare traded credit spreads on April 11, 2014:

Again, Vodafone Group PLC credit spreads are solidly in the safest half of the investment grade peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on April 11 are shown in this graph:

Again the default probabilities for Vodafone Group PLC rank among the highest of the traded investment grade peer group.

We believe a majority of analysts would rank Vodafone Group PLC as “investment grade,” but we also believe that this rating is in danger. The bond market shows a rare combination of relatively narrow spreads on these bonds with high default risk. We believe only two groups of investors would benefit from owning these bonds. The first group would be fund managers running a total bond market index fund like Vanguard’s total bond market fund (BND). The second group is the big data group, if and only if the big data analysts can find a way to reach different conclusions than we have after mining the more than 2 million records of information that were analyzed in this post. Investors who are not in either of these two groups have too many more attractive alternatives to consider Vodafone Group PLC bonds for their portfolio.

Author’s Note
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firm in question. We believe that other authors on SeekingAlpha, Yahoo, at The New York Times, The Financial Times, and the Wall Street Journal do a fine job of this. Our omission of those headlines is intentional. Similarly, to argue that a specific news event is more important than all other news events in the outlook for the firm is something we again believe is inappropriate for this author. Our focus is on current bond prices, credit spreads, and default probabilities, key statistics that we feel are critical for both fixed income and equity investors.