Telefonica, S.A. (TEF) is currently bidding 8.6 billion Euros for the German unit of Koninklijke KPN N.V. (KKPNY). The Spanish telecom giant is closely watched because of the ying and yang of a high dividend yield and a heavy burden of debt. What is the current bond market view of Telefonica, S.A.? Today’s study incorporates 72 May 12 bond trades on 9 U.S. dollar bonds issued by Telefonica Emisiones, S.A.U. with trading volume of $36.4 million.
Telefonica Emisiones, S.A.U. bonds are covered by a guarantee from parent Telefonica, S.A. We use this bond price data to analyze the potential risk and return to bondholders and common shareholders of Telefonica, S.A.
Conclusion: Telefonica, S.A. default probabilities are in the worst half of its industry peer group and its long term default probabilities are rising from a level that was high to begin with. We believe that a slender majority of sophisticated analysts would continue to rank Telefonica, S.A. as investment grade by the 2010 Dodd-Frank Act definition, but we feel that this “investment grade” status is in doubt. Telefonica Emisiones, S.A.U. bonds rank in the bottom 10% of all bonds that traded on May 12 by our usual “best value” criterion, the ratio of credit spread to default probability. 338 other bond issues among 366 that traded heavily on May 12 offered a better credit spread to default probability ratio than the best of the bonds issued by Telefonica Emisiones, S.A.U.
Our first objective is answer whether or not Telefonica, S.A. would be considered “investment grade” in light of the changed definition of investment grade mandated by the Dodd-Frank Act and recently implemented by the Office of the Comptroller of the Currency. For background on Dodd-Frank and related regulatory changes, see our December 6 analysis of Citigroup Inc. (C).
In this note we analyze the current levels and past history of default probabilities for Telefonica, S.A. We also measure the reward, in terms of credit spread, for taking on the default risk of Telefonica Emisiones, S.A.U. bonds.
Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority for 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. We analyze the maturities where the credit spread to default probability ratio is highest for Telefonica, S.A. and Telefonica Emisiones, S.A.U.
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 Telefonica, S.A. ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.37% at one month to 0.28% at 1 year and 1.64% at ten years. In today’s analysis, we make the optimistic assumption that the default risk of Telefonica Emisiones, S.A.U. bonds is identical to that of Telefonica, S.A., the parent. This assumption is optimistic, but we use this assumption as a first approximation. We caution readers that this assumption will lead us to analysis which overstates the attractiveness of the bonds of Telefonica Emisiones, S.A.U.
We explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation on SeekingAlpha.
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 the bond data mentioned above for the 9 Telefonica Emisiones, S.A.U. fixed rate non-call issues in this analysis.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Telefonica Emisiones, S.A.U. 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, interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of Telefonica Emisiones, S.A.U. The second lowest 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 third curve from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on Telefonica Emisiones, S.A.U. bonds. The fourth line from the bottom (the green dots) displays the average yield reported by TRACE on the same day. The highest yield (the red dots) is obviously the maximum yield in each Telefonica Emisiones, S.A.U. issue recorded by TRACE. For the reader’s convenience, we have added a trade volume-weighted credit spread, fitted to the average traded credit spread at each maturity. This curve is shown as black dots joined by black line segments.
The data makes it clear that there is barely any liquidity premium built into the yields of Telefonica Emisiones, S.A.U. above and beyond the “default-adjusted risk free curve” (the risk-free yield curve plus the matched maturity default probabilities for the firm). In our series of bond market notes, this is one of the narrowest liquidity premiums seen to date. We discuss the implications below.
The high, low and average credit spreads at each maturity are graphed below.
The zero coupon credit spreads and zero coupon bond yields for Telefonica Emisiones, S.A.U. are shown in this graph versus zero coupon U.S. Treasury yields. We showed in a recent note on General Electric Company (GE) how we can restate the dividend yield on a credit-adjusted basis. Clearly that adjustment, due to credit risk, would be substantially lower than the traditional dividend yield for Telefonica, S.A. because of the wide credit spreads one can see in this graph:
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. This ratio of spread to default probability is shown in the following table for Telefonica Emisiones, S.A.U. At maturities under 3.5 years, the reward from holding the bonds of Telefonica Emisiones, S.A.U., relative to the matched maturity default probability, is 1.6 to 2.8 basis points of credit spread reward for every basis point of default risk. The ratio of spread to default probability decreases with maturity after that, falling to a credit spread to default ratio between 0.8 and 1.1 times. These ratios are very low and yet they are fairly common in the telecom sector.
The credit spread to default probability ratios are shown in graphic form here. We have again added a traded-weighted polynomial (shown in black) relating the fitted credit spread-default probability ratio to the years to maturity on the underlying bonds.
Relative Value Analysis
Is the reward to risk ratio for Telefonica, S.A. higher than average, lower than average, or just average? Rather than guess, we simply look at the facts. The chart below shows the credit spreads for all fixed rate senior non-call debt issues which traded at least $5 million in volume on May 12, 2014 and had at least 1 year to maturity. There were 366 bond issues that met our criteria. The median credit spread was 0.87% and the average credit spread was 1.19%. This histogram shows the distribution of credit spreads available in the market place.
The next graph shows the distribution of the credit spread to default probability ratios for all 366 issues. The median ratio was 6.57 and the average ratio was 9.33.
How did Telefonica Emisiones, S.A.U. rank on May 12, 2014? There were 338 bond issues that offered a better credit spread to default ratio than the best ranked Telefonica Emisiones, S.A.U. bond. The three Telefonica Emisiones, S.A.U. bonds that traded at least $5 million were ranked between 339 and 361 on the “best value” rankings of these 366 bond issues. Telefonica Emisiones, S.A.U. had lots of company, however, from other telecom sector issuers in the bottom 10 percentiles of the value ranking.
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently prohibited by Kamakura Corporation’s contract with the data vendor. We are working hard to change this so that we may make CUSIPs available in the future. In the meantime, CUSIPs for major issuers can be found easily with an internet such on web pages like this one from the New York Stock Exchange.
Credit Default Swap Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended May 2, 2014 (the most recent week for which data is available), the credit default swap trading volume on Telefonica, S.A. was 115 trades with $493.3 million of notional principal, much heavier trading volume than in the U.S. bond market. The weekly history of notional principal traded on Telefonica, S.A. in the credit default swap market is shown here:
The next graph shows the number of credit default swaps traded on Telefonica, S.A. over the same time period.
On a cumulative basis, the current default probabilities for Telefonica, S.A. range from 0.28% at 1 year to 15.22% at 10 years, as shown in the following graph. The 10 year cumulative default probability for Telefonica, S.A. is one of the highest we have seen in this series of notes on bond market perspectives.
Over the last decade, the 1 year and 5 year default probabilities for Telefonica, S.A. have varied as shown in the following graph. The one year default probability peaked at just under 1.30% in the first half of 2009 during the worst part of the credit crisis and recession in Spain. The 5 year default probability (annualized) peaked at just over 1.25% and it has been rising steadily to nearly the same level in recent months.
The macro-economic factors driving the historical movements in the default probabilities of Telefonica, S.A. 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 Telefonica, S.A. default risk responds to changes in 8 factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 66.9% of the variation in the default probability of Telefonica, S.A. The remainder of the risk is the idiosyncratic default risk of Telefonica, S.A.
Telefonica, S.A. 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 “telecom services” sector, Telefonica, S.A. has the following percentile ranking for its default probabilities among its 337 peers at these maturities:
1 month 86th percentile,
1 year 70th percentile,
3 years 61st percentile,
5 years 59th percentile,
10 years 57th percentile
The percentile ranking for Telefonica, S.A. is worse than the sector median at all maturities.
The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO), for Telefonica, S.A. have changed five times during the decade. A comparison of the legacy credit rating for Telefonica, S.A. with predicted ratings indicates that the statistically predicted rating is identical to the actual legacy credit rating at the low end of the legacy definition of “investment grade.”
Before reaching any conclusions about investment grade status, it is useful to look at some additional market views of Telefonica, S.A. and its peers. The following graph compares the traded credit spreads on Telefonica Emisiones, S.A.U. with the traded credit spreads on the “technology, media and telecommunications” peer group on May 12, 2014:
The credit spreads for Telefonica Emisiones, S.A.U. were near or slightly above the median of the sector peer group. We now look at the matched-maturity default probabilities for Telefonica, S.A. versus that same peer group. Telefonica, S.A. default probabilities are on the high end of the peer group. We remind the reader, however, that the bonds that trade in the secondary market are typically the strongest credits in any given peer group, so this is a stricter standard than the percentile rankings we gave above.
We now compare the traded credit spreads for Telefonica Emisiones, S.A.U. with the traded spreads for every firm with a legacy credit rating in the old-style “investment grade” range. Again, Telefonica Emisiones, S.A.U. spreads are near or slightly above the median of the investment grade peer group.
By the matched maturity default probability criterion, comparing to investment grade firms with bond trades on May 12, Telefonica, S.A.’s default probabilities are well above the median for the investment grade peer group.
With this data in mind, we draw some dispassionate conclusions. Telefonica, S.A. default probabilities are in the worst half of its industry peer group and its long term default probabilities are rising from a level that was high to begin with. We believe that a slender majority of sophisticated analysts would continue to rank Telefonica, S.A. as investment grade by the 2010 Dodd-Frank Act definition, but we feel that this “investment grade” status is in doubt. Are the credit spreads on Telefonica Emisiones, S.A.U. bonds so high that there is more than enough compensation for the risk, putting the bonds in the “good value” category? On the contrary, Telefonica Emisiones, S.A.U. bonds rank in the bottom 10% of all bonds that traded on May 12 by our usual “best value” criterion, the ratio of credit spread to default probability. 338 other bond issues among 366 that traded heavily on May 12 offered a better credit spread to default probability ratio than the best of the bonds issued by Telefonica Emisiones, S.A.U. This is a familiar story in the telecom bond sector.
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.