We last reviewed AT&T Inc. (T) on April 23, 2014, prior to its announcement that it intends to acquire DirecTV (DTV). In this note, we update our prior assessment in light of the DirecTV announcement and the uncertainties associated with that transaction. We turn to the U.S. dollar bonds issued by AT&T Inc. and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on July 25, 2014.
Conclusion: As we said in our April and prior studies, AT&T Inc. is a complex credit, and this complexity has increased with the DirecTV announcement. This is reflected in a high degree of volatility for ATT Inc. default probabilities even though they have remained well below the 1% level at which the Kamakura Troubled Company Index labels a firm as “troubled.” In spite of this concern, we believe a strong majority of analysts would define AT&T Inc. as investment grade.
The attractiveness of the AT&T name, which ranks 15th on Forbes’ list of the world’s most valuable brands , and the firm’s status as an icon of American industry comes with a price. All other things being equal, investors in the bonds of AT&T receive much less reward (in terms of credit spread) relative to the risk they are taking (in terms of default probabilities) compared to the bonds of other issuers. When looking at dividends, the 5.177% traditional dividend yield on AT&T Inc. stock includes a credit risk premium of 0.795% over the 4.382% dividend yield of a risk-free issuer that promises the same present value of dividends as AT&T Inc. over a time horizon near 30 years. The credit-risk-adjusted dividend yield on AT&T Inc. is this 4.382% figure.
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 AT&T Inc. 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 to default probability ratio is highest for AT&T Inc.
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 AT&T Inc. (green line) ranging from one month to 10 years on an annualized basis. We plot the current default probabilities versus the default probabilities for AT&T Inc. at the time of our previous study, April 22, 2014 (orange line). For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The default probabilities range from 0.13% at one month (up 0.01% from April 22) to 0.07% (up 0.01%) at 1 year and 0.51% at ten years (down 0.10%). The default probability decline at 10 years is a significant move downward.
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 senior non-call debt issued by AT&T Inc. and traded on July 25 is reported here.
We used all of the AT&T Inc. bond trades in today’s analysis.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of AT&T Inc. 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 AT&T Inc. 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 AT&T Inc. 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 of AT&T Inc. bond issues 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 AT&T Inc. 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, average, and fitted credit spreads at each maturity are graphed below for AT&T Inc. 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 AT&T Inc., the credit spread to default probability ratio ranges from 1.7 to 4.8 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 AT&T Inc.
Relative Value Analysis
How does the credit spread to default probability ratio for AT&T Inc. 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 AT&T Inc. with all fixed-rate non-call senior bond issues with a daily trading volume of at least $5 million and a maturity of 1 year or more. The first graph shows a histogram of the credit spreads that prevailed on these issues on July 25, 2014:
There were 216 issues that met our criteria on July 25. The median credit spread was 0.969% and the average was 1.309%. 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 4.697 and the average ratio is 16.174.
The ratio of credit spread to default probability is shown in this chart for all of AT&T Inc. bonds with at least $5 million in trading volume and maturities over 1 year. The 8 heavily traded bonds of AT&T Inc. bonds rank from 119th to 207th out of 216 heavily traded bonds. Every one of the AT&T bonds ranks below the 108th bond, the median of all heavily traded bonds when ranked by our value criterion.
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently illegal under 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 AT&T Inc. 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 AT&T Inc., which pays its dividends once per year. 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 AT&T Inc. over almost 30 years. We use this data from SeekingAlpha.com in our analysis.
The history of AT&T Inc. 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 AT&T Inc. at the quarterly rate of $0.46 and using the present value factors implied by the firm’s bond prices, we find that the long term credit-adjusted dividend yield is 4.382%, 0.795% less than the traditional dividend yield of 5.177% (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 AT&T Inc. 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 reference name. We summarize the trading activity for AT&T Inc. in the following table, which reports on credit default swap trading for the week ended July 18, 2014 (the most recent week for which data is available). AT&T Inc. ranked 418th in trading volume during the week.
The notional principal of credit default swaps traded on AT&T Inc. over the 4 year period ended July 18, 2014 is summarized in this graph:
The number of credit default swap contracts traded on AT&T Inc. is shown here:
On a cumulative basis, the current default probabilities (in green) for AT&T Inc. range from 0.07% at 1 year to 5.03% at 10 years. The April 22, 2014 cumulative default probabilities are graphed in orange. The 10 year cumulative default probability is more than 10 times higher than the same default probability in our recent study on International Business Machines Corp. (IBM).
The 1 year default probability (in blue) peaked at almost 0.60% in 2008-2009. The 5 year default probability (in yellow) peaked near 0.60% on an annualized basis in 2005.
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 AT&T Inc. 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 AT&T Inc. default risk responds to changes in 6 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 48.4% of the variation in the default probability of AT&T Inc. The remaining variation is the estimated idiosyncratic credit risk of the firm.
AT&T Inc. 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, AT&T Inc. has the following percentile ranking for its default probabilities among its 334 peers at these maturities:
1 month 73rd percentile
1 year 49th percentile
3 years 31st percentile
5 years 24th percentile
10 years 21st percentile
AT&T Inc. percentile rankings improve as the maturity lengthens, but they are much higher than the firms we have studied most recently in this series of notes.
Taking still another view, the actual and statistically predicted AT&T Inc. 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 twice in the last decade.
We postpone our conclusions briefly to view some more facts. The “technology, media and telecommunications” peer credit spreads on July 25 are shown here in light blue, with AT&T Inc. credit spreads plotted in dark blue. AT&T Inc. credit spreads are near or slightly below the median of the peer group. We remind readers that the traded bond peer group generally has higher average quality than the full peer group universe.
The matched maturity default probabilities for the “technology, media and telecommunications” peer group with bonds traded on July 25 are shown in this graph:
AT&T Inc. is near the median of the peer group by this measure. Investment grade credit spreads on all bonds traded on July 25 are shown here in light blue with AT&T Inc. credit spreads plotted in dark blue:
AT&T Inc. credit spreads are below the median of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus AT&T Inc.:
AT&T Inc. is at or above the median of the investment grade peer group, especially at the longer maturities.
As we said in our April and prior studies, AT&T Inc. is a complex credit, and this complexity has increased with the DirecTV announcement. The entire telecommunications sector faces a constantly changing technological landscape and a higher than average level of default risk. This is reflected in a high degree of volatility for ATT Inc. default probabilities even though they have remained well below the 1% level at which the Kamakura Troubled Company Index labels a firm as “troubled.” In spite of this concern, we believe a strong majority of analysts would define AT&T Inc. as investment grade.
Even though the default probabilities of AT&T are among the best quartile of its industry peers for 5 years and longer, the ratio of the credit spreads to default probabilities for the firm are very low across the board. The attractiveness of the AT&T name, which ranks 15th on Forbes’ list of the world’s most valuable brands, and the firm’s status as an icon of American industry comes with a price. All other things being equal, investors in the bonds of AT&T receive much less reward (in terms of credit spread) relative to the risk they are taking (in terms of default probabilities) compared to the bonds of other issuers. When looking at dividends, the 5.177% traditional dividend yield on AT&T Inc. stock includes a credit risk premium of 0.795% over the 4.382% dividend yield of a risk-free issuer that promises the same present value of dividends as AT&T Inc. over a time horizon near 30 years. The credit-risk-adjusted dividend yield on AT&T Inc. is this 4.382% figure.
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.