Target Corporation (TGT), founded in 1902, is the second largest discount retailer in the United States. In this note, we turn to the U.S. dollar bonds issued by Target Corporation and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on June 23, 2014 . A total of 95 trades were reported on 12 fixed-rate bond issues of Target Corporation with June 23 trading volume of $69 million.
Conclusion: We believe that a majority of sophisticated analysts would continue to rank Target Corporation as “investment grade” because of its long-run default probability ranking in the best 20% of the retailing peer group. A web search on Target Corporation turns up the phrase “expect more, pay less,” and that is a good description of the value proposition that Target Corporation bonds offer in today’s market.
On June 23, 255 of 367 heavily traded bonds offered a better credit spread to default probability ratio than the best Target Corporation bond issue. We suggest investors expect more and pay less than the current price on Target Corporation bonds.
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 Target Corporation to be “investment grade” under theJune 13, 2012 rules mandated by the Dodd-Frank Act of 2010. For a discussion of the implications of the Dodd-Frank Act on the definition of investment grade, see our post on Citigroup in December.
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. In this note, we also analyze the maturities where the credit spread/default probability ratio is highest for Target Corporation.
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 Target Corporation (green line) ranging from one month to 10 years on an annualized basis. They are plotted versus the default probabilities for Target Corporation six months earlier on December 23, 2013 (orange line). For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The current Target Corporation default probabilities range from 0.05% at one month to 0.04% at 1 year and 0.23% at ten years.
We also explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation on www.SeekingAlpha.com.
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. The total of all fixed rate debt issued by Target Corporation and traded on June 23 is reported here. Target Corporation was the 20th most actively traded issuer.
After eliminating callable bonds and non-senior bonds from the total for Target Corporation, we analyzed 93 trades on 11 issues with a notional principal traded of $68.6 million.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Target 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 matches the maturity of the traded bonds of the Target 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 line graphs the lowest yield reported by TRACE on that day on Target Corporation bonds. The green line displays the value-weighted average yield reported by TRACE on the same day. The red line is the maximum yield in each Target Corporation bond issue recorded by TRACE. The black dots and connecting black line represent the yields consistent with a trade-weighted fitted credit spread we discuss below.
The graph shows an increasing “liquidity premium” as maturity lengthens for the bonds of Target Corporation. This increasing liquidity premium is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for Target Corporation. We have done nothing to smooth the data reported by TRACE (other than eliminating erroneous data as explained above), which includes both large lot and small lot bond trades. For the reader’s convenience, we fitted a trade-weighted cubic polynomial that explains the average spread as a 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 Target Corporation, the credit spread to default probability ratio ranges from 2.6 to 5.3 times. The ratios of spread to default probability for all traded bond issues are shown here:
The credit spread to default probability ratios are shown in graphic form below for Target Corporation.
Relative Value Analysis
How does the credit spread to default probability ratio for Target Corporation compare to other bonds available in the market place? Is it high, low or average? We answer that question by comparing the credit spread to default probability ratio for Target Corporation with all 367 bond issues with a daily trading volume of at least $5 million on June 23 and a maturity of 1 year or more. The first graph shows a histogram of the credit spreads that prevailed on these issues on June 23, 2014:
The median credit spread was 0.845% and the average was 1.134%. The distribution of the reward to risk ratio, the credit spread divided by the matched maturity default probability, is shown in the next histogram. The median ratio is 8.49 and the average ratio is 12.77.
The ratio of credit spread to default probability is shown in this chart for all of the Target Corporation bonds with at least $5 million in trading volume. All 3 of the Target Corporation bonds rank in the bottom one-third of all heavily traded bonds when ranked by our value criterion. Overall, the Target Corporation bonds rank from 256 to 291 of the 367 heavily traded bonds.
For a recent ranking of heavily traded bonds with maturities of one to 5 years, please see this ranking from June 16 , 2014.
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 Target Corporation 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 Target Corporation. 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 Target Corporation over almost 30 years. We use this data from SeekingAlpha.com:
The history of Target Corporation dividends is nicely summarized on the NASDAQ website.
Readers who prefer a real time update of the dividend yield information can see that here. After projecting the flow of dividends from Target Corporation at the quarterly rate of $0.52 and using the present value factors implied by Target Corporation bond prices, we find that the long term credit-adjusted dividend yield is 3.117%, 0.433% less than the traditional dividend yield of 3.550% (note that the yield on the SeekingAlpha website is different because of lags in updating the figure as the stock price changes). Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that Target Corporation may default, ending the dividend stream. The bond-based discount factors incorporate this fact. We show the calculation below for just the first 24 months of cash flows.
Credit Default Swap Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by referece name. For the week ended June 13, 2014 (the most recent week for which data is available), the credit default swap trading volume on Target Corporation was 14 trades for $63 million, ranking the firm 682nd among 977 counterparties with at least one trade during the week.
The notional principal traded weekly in the credit default swap market on Target Corporation is shown in this graph of data from the Depository Trust & Clearing Corporation:
The number of credit default swaps traded weekly on Target Corporation is shown in this history graph:
On a cumulative basis, the current default probabilities (in green) for Target Corporation range from 0.04% at 1 year to 2.24% at 10 years. The December 23, 2013 cumulative default probabilities are graphed in orange.
Over the last decade, the 1 year and 5 year annualized default probabilities for Target Corporation spiked during the credit crisis. The 1 year default probability peaked at slightly over 0.70% in 2008-2009. The 5 year default probability peaked at slightly over 0.40% on an annualized basis at the same time.
The firm’s default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. For an explanation, see the references in each Instablog posted by Kamakura Corporation. 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 Target Corporation has 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 Target Corporation default risk responds to changes in 7 risk factors among the macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 57.7% of the variation in the default probability of Target Corporation. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Target Corporation can be compared with its peers in the same industry sector, as defined by Target Corporation itself and reported by Compustat. For the USA “retailing” sector, Target Corporation has the following percentile ranking for its default probabilities among its 192 peers at these maturities:
1 month 66th percentile,
1 year 48th percentile,
3 years 35th percentile,
5 years 17th percentile,
10 years 10th percentile,
The short term ranking of Target Corporation relative to its peers is higher because business conditions are so good currently that they rank at the 99th percentile for the period from 1990 to the present. The strong corporate business conditions drive the default probabilities of all firms to low levels. Over a longer time horizon, Target Corporation ranks in the safest one-fifth of its peer group from a credit risk perspective.
Taking still another view, the actual and statistically predicted Target Corporation credit ratings both show a rating in the “investment grade” territory. The statistically predicted rating is 1 notch below the legacy rating from firms like the Standard & Poor’s affiliate of McGraw-Hill (MHFI) and Moody’s Investors Service (MCO). The legacy ratings of the company have changed only once in the last decade.
We postpone our conclusions briefly to view some more facts. The “retailing” peer credit spreads on June 23 are shown here in light blue, with Target Corporation credit spreads plotted in dark blue. Target Corporation credit spreads are slightly below the median.
The matched maturity default probabilities for the “retailing” peer group with bonds traded on June 23 are shown in this graph:
Target Corporation is roughly in the middle of the peer group by this measure. Investment grade credit spreads on all bonds traded on June 23 are shown here in light blue with Target Corporation credit spreads plotted in dark blue:
Target Corporation falls well below the middle of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus Target Corporation:
The scale of the graph makes viewing difficult but Target Corporation is again near the middle of the pack.
We believe that a majority of sophisticated analysts would continue to rank Target Corporation as “investment grade” because of its long-run default probability ranking in the best 20% of the retailing peer group. A web search on Target Corporation turns up the phrase “expect more, pay less,” and that is a good description of the value proposition that Target Corporation bonds offer in today’s market. On June 23, 255 of 367 heavily traded bonds offered a better credit spread to default probability ratio than the best Target Corporation bond issue. We suggest investors expect more and pay less than the current price on Target Corporation bonds.
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.