We last reviewed Vodafone Group PLC (VOD) on April 15, 2014. Since then, the European Commission has approved Vodafone Group PLC’s acquisition of the Spanish cable operator Ono. In order to get an updated bond market view of the firm, we turn to the U.S. dollar bonds issued by Vodafone Group PLC and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on August 4, 2014.
A total of 53 trades were reported on 10 fixed-rate bond issues of Vodafone Group PLC with trading volume of $38.2 million on August 4. Vodafone Group PLC was the 18th most actively traded corporate bond issuer on August 4. We use this information for three purposes: to evaluate the risk and return on the firm’s bonds, to evaluate the firm’s credit risk-adjusted dividend yield, and to reach a conclusion on investment grade status by the modern “Dodd-Frank” definition.
Conclusion: We believe a majority of analysts would rank Vodafone Group PLC as “investment grade.” We also believe that this investment grade status is still in danger, even after the very large drop in default probabilities that we document below. How about the value in the bonds? The bond market continues to show a rare combination of relatively narrow spreads on these bonds with high default risk. All of the heavily traded bonds of Vodafone Group PLC rank in the bottom 10% of all bonds by our usual value criterion, the ratio of credit spread to default probability. We show below that 177 of 189 heavily traded bonds offered better value than the heavily traded bonds of Vodafone Group PLC.
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 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 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 (green line) ranging from one month to 10 years on an annualized basis. We plot the current default probabilities versus the default probabilities for Vodafone Group PLC at the time of our previous study, April 15, 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 current annualized default probabilities range from 0.32% at one month (a massive drop from 1.25% in April) to 0.23% at 1 year (down 0.56% since April) and 0.71% at ten years (down 0.63%). These default probabilities declines are very significant, but default probabilities remain higher than most firms reviewed in this series of notes.
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 Vodafone Group PLC and traded on August 4 is reported here.
We used all but 2 of the Vodafone Group PLC bond trades in today’s 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 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 line graphs the lowest yield reported by TRACE on that day on Vodafone Group PLC 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 Vodafone Group PLC 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 Vodafone Group PLC. 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 Vodafone Group PLC. 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 Vodafone Group PLC, the credit spread to default probability ratio ranges from 1.6 to 2.6 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 Vodafone Group PLC.
Relative Value Analysis
How does the credit spread to default probability ratio for Vodafone Group PLC 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 Vodafone Group PLC 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 August 4, 2014:
There were 189 issues that met our criteria on August 4. The median credit spread was 0.795% and the average was 1.133%. 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 10.186 and the average ratio is 20.808.
The ratio of credit spread to default probability is shown in this chart for all of Vodafone Group PLC bonds with at least $5 million in trading volume and maturities over 1 year. The 4 heavily traded bonds of Vodafone Group PLC rank from 178th to 182nd out of 189 heavily traded bonds. Every one of the Vodafone Group PLC bonds ranks in the bottom 10% of all heavily traded bonds when ranked by our value criterion. Note also that telecommunications firms take up all but one of the rankings from 177 to 189.
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. This article neatly summarizes which institutions have restricted availability of CUSIPs in order to maximize their profits as a monopoly supplier of the data.
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 Vodafone Group PLC in the following table, which reports on credit default swap trading for the week ended July 25, 2014 (the most recent week for which data is available). Vodafone Group PLC ranked 485th in trading volume during the week.
The notional principal of credit default swaps traded on Vodafone Group PLC over the 4 year period ended July 25, 2014 is summarized in this graph:
The number of credit default swap contracts traded on Vodafone Group PLC is shown here:
On a cumulative basis, the current default probabilities (shown in green) for Vodafone Group PLC range from 0.23% at 1 year (down from 0.79% in April) to 6.86% at 10 years, a massive 5.72% drop from 12.58% in April. The April 15, 2014 cumulative default probabilities are graphed in orange.
The 1 year default probability (in blue) peaked at more than 5.00% in 2006. The 5 year default probability (in yellow) peaked near 3.00% 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 Vodafone Group PLC 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 Vodafone Group PLC default risk responds to changes in 8 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 55.5% 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 324 peers at these maturities:
1 month 85th percentile
1 year 71st percentile
3 years 75th percentile
5 years 77th percentile
10 years 78th percentile
Vodafone Group PLC percentile ranking remain very high even after the large drop in default probabilities since April. The rankings 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 Vodafone Group PLC credit ratings both show a rating in the “investment grade” territory. The statistically predicted rating is the same as 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 August 4 are shown here in light blue, with Vodafone Group PLC credit spreads plotted in dark blue. Vodafone Group PLC credit spreads are near 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 August 4 are shown in this graph:
Vodafone Group PLC is above the median of the peer group by this measure. Investment grade credit spreads on all bonds traded on August 4 are shown here in light blue with Vodafone Group PLC credit spreads plotted in dark blue:
Vodafone Group PLC credit spreads are near the median of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus Vodafone Group PLC:
Vodafone Group PLC is above the median of the investment grade peer group, especially at the longer maturities.
Conclusion: We believe a majority of analysts would rank Vodafone Group PLC as “investment grade.” We also believe that this investment grade status is still in danger, even after the very large drop in default probabilities that we documented above. How about the value in the bonds? The bond market continues to show a rare combination of relatively narrow spreads on these bonds with high default risk. All of the heavily traded bonds of Vodafone Group PLC rank in the bottom 10% of all bonds by our usual value criterion, the ratio of credit spread to default probability. We showed above that 177 of 189 heavily traded bonds offered better value than the heavily traded bonds of Vodafone Group PLC.
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.