We last analyzed the bond market view of American Express Company (AXP) on August 8, 2013. In this note, we use the bond market data for the most heavily traded American Express Company legal entity, American Express Credit Corporation, to analyze the risk and return of American Express-related bonds, the dividend, and the status of the “investment grade” ranking on American Express Company under the modern Dodd-Frank definition. We use bond trade data for June 13, 2014 to draw our conclusions. We note that there was also trading on that day for American Express Company itself and for American Express Centurion Bank, but we postpone an analysis of those bonds for another day. American Express Credit Corporation issued $1.675 billion of 3 year notes on June 2, 2014.
The indenture provisions describing the financial links with American Express Company and other legal entities in the American Express family are described on pages 18 and 19 of the prospectus for the note issue. For purposes of this analysis, as a first approximation, we assume that the credit risk of American Express Company and American Express Credit Corporation are identical.
Conclusion: American Express Company ranks as number 26 on Forbes’ ranking of the most valuable world-wide brands . Early in this series, we have seen many “high value brand” company bond issues are over-priced compared to the credit spread to default probability ratios offered by more “normal” firms. American Express Company ranks among the least risky 5 percent of the diversified financial sector in the United States. Moreover, it offers a higher level of credit spread per basis point of default risk than 246 of the 252 heavily traded bond issues on June 13. All of the American Express Company-related bond issues ranked in the top 20% by our “best value” criterion.
If there is a concern among analysts about American Express Company, it is reflected in the jump in default risk that American Express Company experienced in the credit crisis. In spite of these concerns, we believe that a very strong majority of serious analysts would rate American Express Company as investment grade by the new Dodd-Frank definition.
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 American Express Company to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. The U.S. Office of the Comptroller of the Currency has announced its implementation of the Dodd-Frank rules in 2012. 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 to default probability ratio is highest for American Express Company.
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 American Express Company 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 default probabilities, in green, range from 0.00% at one month (the default probabilities are positive but round to zero at 2 decimal places) to 0.00% at 1 year and 0.05% at ten years. The August 8, 2013 default probabilities used in our prior study are shown in yellow.
We also explain the source and methodology for the default probabilities below.
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. American Express Credit Corporation was the 18th most heavily traded corporate bond issuer in the U.S. fixed rate bond market on June 13, with 99 trades in 15 issues for a daily volume of $59 million. We eliminated all non-senior non-call bonds from this total to get the 13 bonds used for today’s study.
The graph below shows 6 different yield “curves” that are relevant to a risk and return analysis of American Express Credit Corporation 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 American Express Credit Corporation. 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 American Express Credit Corporation 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 American Express Credit Corporation issue recorded by TRACE. The black dots and connecting black line show the yield consistent with the best fitting trade-weighted credit spread explained below.
The graph shows a fairly rare flat “liquidity premium” as maturity lengthens for the bonds of American Express Credit Corporation, due in part because the bonds analyzed all have maturities of 5 years or less.
The high, low, average and fitted credit spreads at each maturity are graphed below for American Express Credit Corporation. 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 American Express Company, the credit spread to default probability ratio generally ranges widely from 19 to more than 200 times.
The same ratios from our previous study on August 8, 2013 are shown here:
The credit spread to default probability ratios are shown in graphic form below for American Express Company and American Express Credit Corporation on June 13, 2014. The graph shows the gentle decline in the credit spread to default probability ratio.
Relative Value Analysis
Are these reward to risk ratios “normal”? Are they above or below average? The best way to answer that question 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 June 13. The distribution of the credit spreads on the 252 traded bonds that met these criteria on June 13 is first plotted in this histogram:
The median credit spread for all 252 trades was 0.846%. The average credit spread was 1.169%. The next graph shows the wide dispersion of the credit spread to default probability ratios on those 252 June 13 trades:
The median credit spread to default probability ratio on those 252 trades was 7.951 and the average was 14.263. Only 5 out of 252 large trades on June 13 had better credit spread to default probability ratios than the best ratio for any of the American Express Company-related bonds which traded at least $5 million in volume. The lowest ranked American Express Company-related bond ranked 46th of the 252 bonds. This means that all of the heavily traded American Express Company bonds ranked in the top 20% by our “best value” criterion, the credit spread to default probability ratio. We list the credit spread to default probability ratios for bond trades over $5 million in volume for American Express Company-related bonds here:
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-Adjusted Dividend Yield
We explained in a recent post on General Electric Company (GE) how default probabilities and the associated credit spreads for a bond issuer can be used to calculate the credit-adjusted dividend yield on a stock . That analysis makes use of a comparison between the yield on the issuer’s promise to pay $1 in the future versus the yield on a similar promise by the U.S. government to pay $1 at the same time. Using the maximum smoothness approach to both the U.S. Treasury curve and to American Express Company credit spreads, we can generate the zero coupon bond yields on their promise to pay $1 in the future, which are shown in this graph:
The widening of zero coupon credit spreads is important. If we discount dividend payments for maturities of 1, 10 and almost 30 years, we can solve for the “credit risk free” dividend for American Express Company This would be the dividend level for a default risk-free issuer (we assume as a first approximation that the U.S. Treasury is default risk-free) that has the same present value as the flow of dividends from American Express Company over almost 30 years. We use this data from SeekingAlpha.com:
The history of American Express Company dividends is nicely summarized on the NASDAQ website. We caution investors that the dividend history on the American Express Company website has not been updated recently and is six months out of date.
Readers who prefer a real time update of the dividend yield information can see that here. After projecting the flow of dividends from American Express Company at the quarterly rate of $0.26 and using the present value factors implied by American Express Company bond prices, we find that the long term credit-adjusted dividend yield is 1.09%, only 0.02% less than the traditional dividend yield of 1.11%. Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that American Express Company may default, ending the dividend stream. The bond-based discount factors incorporate this fact. The two measures are very close because of the narrow spreads and low default probabilities for American Express Company and because of the high level of the stock price relative to the dividend payment amount.
The first two years of cash flow assumed and discount factors used are shown here to illustrate the methodology:
Credit Default Swap Analysis
For the week ended June 6, 2014 (the most recent week for which data is available), the Depository Trust & Clearing Corporation reported 10 credit default swap trades with notional principal of $46.5 million on American Express Company. This made American Express Company the 481st-ranked credit default swap reference name by notional principal traded during the week.
The weekly notional principal traded on American Express Company is shown in this graph:
The number of contracts traded each week on American Express Company is shown here:
On a cumulative basis, the default probabilities for American Express Company range from 0.00% at 1 year to 0.46% at 10 years, as shown in green in the following graph. This is a reduction of 0.04% in 10 year risk relative to our prior study on August 8, 2013. The default probabilities on that date are graphed in yellow.
Over the last decade, the 1 year and 5 year default probabilities for American Express Company have varied as shown in the following graph. The one year default probability peaked at just under 2.00% and the 5 year default probability peaked at just over 0.50% during the heart of the credit crisis in 2008-2009. This is a very good performance relative to other financial firms which were failed or rescued during the credit crisis. American Express Company borrowed under the Federal government’s Commercial Paper Funding Facility for 106 days in 2008-2010, with maximum borrowings of $4.47 billion according to a recent Kamakura Corporation study .
The macro-economic factors driving the historical movements in the default probabilities of American Express Company included 6 of the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. Together, these factors explained 85.4% of the variation of the American Express Company 1 year default probability from 1990 to the present. This represents the systematic default risk of the firm. The remaining variation in the default probability is the idiosyncratic default risk of the firm.
American Express Company can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the USA diversified financials sector, American Express Company has the following percentile ranking for its default probabilities among its 225 peers at these maturities:
1 month 0th percentile, tied with many others, down 10 percentage points since August
1 year 0th percentile, tied with many others, down 10 points
3 years 0th percentile, tied with one other, down 7 points
5 years 4th percentile, unchanged since August
10 years 4th percentile, up 2 points since August
American Express Company is in the least risky 5% of the USA diversified financials sector at all maturities, and the relative risk has declined at all maturities except the 5 and 10 year points since August. A comparison of the legacy credit rating for American Express Company with predicted ratings indicates that the statistically predicted rating is equal to the actual legacy rating assigned to the company. The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO), for American Express Company have changed only twice during the last decade.
Before jumping to conclusions about the investment grade status of American Express Company, we look at 4 more comparisons with two different peer groups. The first graph compares the credit spreads of American Express Credit Corporation with the credit spreads on all other bonds traded on June 13, 2014 in the “Banks/Finance” peer group:
Clearly, the American Express Credit Corporation spreads are below the median of the peer group at short maturities. Next, we compare the matched-maturity default probabilities for American Express Company with the default probabilities for the same peer bond issues traded on June 13:
The American Express Company default probabilities are among the lowest in the peer group. Next, we compare credit spreads for American Express Credit Corporation with the credit spreads for firms with legacy “investment grade” credit ratings:
Again, the American Express Credit Corporation credit spreads are below the peer group median. Finally, we compare the matched-maturity default probabilities for American Express Company with the default probabilities on the investment grade bonds traded on June 13:
Again, the default probability comparison shows American Express Company as one of the safest firms in the investment grade peer group.
American Express Company ranks as number 26 on Forbes’ ranking of the most valuable world-wide brands. Early in this series, we have seen many “high value brand” companies have bonds that are over-priced compared to the credit spread to default probability ratios offered by more “normal” firms. American Express Company ranks among the least risky 5 percent of the diversified financial sector in the United States. Moreover, it offers a higher level of credit spread per basis point of default risk than 246 of the 252 heavily traded bond issues on June 13. All of the American Express Company-related bond issues ranked in the top 20% by our “best value” criterion.
If there is a concern among analysts about American Express Company, it is reflected in the jump in default risk that American Express Company experienced in the credit crisis. The company’s dependence on wholesale funding, along with many of its peers, is a potential risk factor that was mitigated by U.S. government intervention in financial markets during the last credit crisis. The risk is that government intervention in the next crisis either does not happen or happens to a much more limited extent than it did in 2008-2009. In spite of these concerns, we believe that a very strong majority of serious analysts would rate American Express Company as investment grade.
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.