Kamakura’s troubled company index showed a new record for all-time best credit conditions on August 4, 2014. The massive credit crisis lawsuits against the largest banks in the land are steadily moving toward resolution. At the same time, the new top management team at Citigroup has been pruning its world-wide businesses to restore the firm to profitability. In light of these developments, we review traded bond prices of both Citigroup Inc. (C) and its financial services peers to reach conclusions about these questions:
- What is the current default risk of Citigroup Inc.?
- What is the credit-adjusted dividend yield on Citigroup Inc. common stock?
- From a marginal cost of funds perspective, is Citigroup Inc. competitive with its peers?
- Do the bonds of Citigroup Inc. offer “good value” from an investment perspective?
- Is Citigroup Inc. an “investment grade” firm by the new Dodd-Frank definition?
Conclusion: The default probabilities of Citigroup Inc. are very low compared to their peak in the credit crisis, and they have been falling over the last five months. We believe that a strong majority of sophisticated analysts would continue to rank Citigroup Inc. as investment grade by the 2010 Dodd-Frank Act definition. Regular readers of these notes know that low default probabilities, per se, are not enough to make the bonds of a given issuer “good value.” How do Citigroup Inc. bonds rank among all other bonds by the ratio of credit spread to default probability? Citigroup Inc. bonds rank in the top third of all bonds traded on September 30 by our “best value” criterion. Only 66 of 251 heavily traded bonds on September 30, 2014 offered better value than the best value Citigroup Inc. bond.
Interest rate risk managers at major firms like Citigroup Inc. use the marginal cost of funds reflected in the bond market to centralize interest rate risk and to measure internal profitability based on a “transfer pricing yield curve.” Part of our objective in this note is to derive this curve. We also answer whether or not Citigroup Inc. would be considered “investment grade” in light of the changed definition of investment grade mandated by Dodd-Frank 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 at the link above.
In this note we analyze the updated current levels and past history of default probabilities for Citigroup Inc. We also measure the reward, in terms of credit spread, for taking on the default risk of Citigroup Inc. bonds. On September 30, 25 Citigroup Inc. senior non-call fixed rate bonds were traded 205 times for $67.6 million in volume. Citigroup was the 13th most heavily traded bond issuer in the U.S. bond market on September 30, 2014.
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 Citigroup 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 (in blue) for Citigroup Inc. ranging from one month to 10 years on an annualized basis, compared to the default probabilities for May 2, 2014 (in yellow), which we used in our prior study. The default probabilities range from 0.03% at one month (down 0.04% from May) to 0.01% at 1 year (down 0.02%) and 0.07% at ten years (down 0.03%).
We explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation on SeekingAlpha. For maturities longer than 10 years, we assume that the 10 year default probability is a reasonable estimate of the credit risk of those longer maturities.
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. After excluding bonds with very small trading volume, we used 187 trades with a notional principal amount of $67.1 million in this note.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Citigroup 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, interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of Citigroup Inc. 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 Citigroup Inc. 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 Citigroup Inc. 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 a sizable liquidity premium built into the yields of Citigroup Inc. above and beyond the “default-adjusted risk free curve” (the risk-free yield curve plus the matched maturity default probabilities for the firm). The credit spreads generally widen with maturity, the normal pattern for a high quality credit, with the exception of three bonds with maturities near 30 years.
The high, low and average credit spreads at each maturity are graphed below. Credit spreads are gradually increasing with the maturity of the bonds, with the exception of the maturities near 30 years.
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 Citigroup Inc. At almost all maturities under 2.5 years, the reward from holding the bonds of Citigroup Inc., relative to the matched maturity default probability, is 23 to 91 basis points of credit spread reward for every basis point of default risk. The ratio of spread to default probability decreases with maturity once the maturity of the bonds exceeds 2.5 years, falling to a spread to default ratio between 9 and 25 times. The reward to risk ratio has widened somewhat from our May analysis, a long-standing trend for Citigroup Inc.
The credit spread to default probability ratios are shown in graphic form here. We have again added a traded-weighted polynomial 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 Citigroup Inc. 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 September 30, 2014 and had at least 1 year to maturity. There were 251 bond issues that met our criteria. The median credit spread was 1.092% and the average credit spread was 1.698%. 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 251 issues. The median ratio was 12.032 and the average ratio was 12.074.
How did Citigroup rank on September 30, 2014? Only 66 of 251 bond issues offered a better credit spread to default ratio than the best ranked Citigroup Inc. bond. The Citigroup Inc. bonds that traded at least $5 million were ranked 67th and 78thof 251 issues, firmly in the top one third of all bonds when ranked by “best value.”
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. Thanks to FINRA, the CUSIPs have been put into the public domain for free via this FINRA-affiliated website.
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 Citigroup 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:
This yield curve represents the marginal cost of funds to Citigroup Inc. and is at the heart of transfer pricing, the disciplined measurement of the source of interest rate-related income and expense for each business unit. 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 Citigroup Inc. 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 Citigroup Inc. over almost 30 years. We use this data from SeekingAlpha.com:
The history of Citigroup Inc. dividends is nicely summarized on the company website.
After projecting the flow of dividends from Citigroup Inc. at the quarterly rate of $0.01 and using the present value factors implied by Citigroup Inc. bond prices, we find that the long term credit-adjusted dividend yield is 0.066%, 0.013% less than the traditional dividend yield of 0.079%. Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that Citigroup Inc. may default, ending the dividend stream. The bond-based discount factors incorporate this fact.
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 September 26, 2014 (the most recent week for which data is available), the credit default swap trading volume on Citigroup Inc. was 24 trades with $372.4 million of notional principal. Citigroup Inc. was the 55th most heavily traded reference name during the week.
The notional principal traded on Citigroup Inc. in the credit default swap market since July 2010 is shown here:
The next graph shows the number of credit default swaps traded on Citigroup Inc. over the same time period.
On a cumulative basis, the current default probabilities (shown in blue) for Citigroup Inc. range from 0.01% at 1 year (down 0.02% from May, shown in yellow) to 0.66% at 10 years (down 0.33% from May), as shown in the following graph. This is a dramatic improvement.
Over the last decade, the 1 year and 5 year default probabilities for Citigroup Inc. have varied as shown in the following graph. The one year default probability peaked at just under 40% in the first half of 2009 during the worst part of the credit crisis. The 5 year default probability (annualized) peaked at just over 10%.
Comparison of Citigroup Inc. Credit Spreads with the U.S. Dollar Cost of Funds Index
How does the marginal cost of funding for Citigroup Inc. compare with Kamakura’s U.S. Dollar Cost of Funds IndexTM, a measure of the composite current credit spreads on the four largest deposit-taking banks in the United States? We use the U.S. Dollar Cost of Funds Index based on observable bond trades on September 30, 2014 . We calculate the difference between the trade-weighted average credit spreads for Citigroup Inc. and the U.S. Dollar Cost of Funds credit spreads for the identical maturities for all observable bond trades with at least $1 million in trading volume. The bonds used are senior non-call fixed rate debt issues reported by TRACE via Market Axess. The comparison between Citigroup Inc. credit spreads (in black) and the underlying U.S. Dollar Cost of Funds Index credit spreads (in brown) are shown here:
On a bond by bond basis, the results are summarized in this table:
On a simple average basis, equally weighting each issue, Citigroup Inc.’s average funding differential versus the U.S. Dollar Cost of Funds Index is a premium, or extra credit spread, of 0.028%. This means that the firm’s marginal cost of funds is nearly indistinguishable from its large bank peers, something essential from a competitive perspective.
The macro-economic factors driving the historical movements in the default probabilities of Citigroup Inc. 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. This assumption is certainly false in the case of Citigroup Inc., where the new management team has dramatically reduced the firm’s exposure to U.S. home price risk. With that caveat, the historical analysis shows that Citigroup Inc. default risk responds to changes in five factors among those listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 75.3% of the variation in the default probability of Citigroup Inc. The remainder of the risk is the idiosyncratic default risk of Citigroup Inc.
Citigroup Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the USA “diversified financials” sector, Citigroup Inc. has the following percentile ranking for its default probabilities among its 228 peers at these maturities:
1 month 60th percentile, down 21 percentiles since May
1 year 31st percentile, down 28
3 years 31st percentile, down 17
5 years 15th percentile, down 5
10 years 10th percentile, down 2
the decrease in Citigroup Inc. default probabilities that we discussed above has resulted in an improvement of the relative ranking of the company within its peer group. The percentile ranking for Citigroup Inc. at 5 and 10 years is in the safest 15% of credit risk among diversified financial firms.
The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO), for Citigroup Inc. have changed four times during the decade. A comparison of the legacy credit rating for Citigroup Inc. with predicted ratings indicates that the statistically predicted rating is exactly the same as the actual legacy credit rating. Both the actual and predicted ratings are “investment grade” by traditional credit rating standards of Moody’s Investors Service and the Standard & Poor’s affiliate of McGraw-Hill.
Before reaching any conclusions about investment grade status, it is useful to look at some additional market views of Citigroup Inc. and its peers. The following graph compares the traded credit spreads on Citigroup Inc. with the traded credit spreads on the “banks/finance” peer group on September 30, 2014:
The credit spreads for Citigroup Inc. were near the middle of the sector peer group. We now look at the matched-maturity default probabilities for Citigroup Inc. versus that same peer group. Citigroup Inc. default probabilities are slightly below average for the peer group even though its spreads were near the average.
We now compare the traded credit spreads for Citigroup Inc. with the traded spreads for every firm with a legacy credit rating in the old-style “investment grade” range. Again, Citigroup Inc. spreads are near the average of this peer group in most cases.
By the matched maturity default probability criterion, comparing to investment grade firms with bond trades on September 30, Citigroup Inc.’s default probabilities are well below average.
The default probabilities of Citigroup Inc. are very low compared to their peak in the credit crisis, and they have been falling over the last five months. We believe that a strong majority of sophisticated analysts would continue to rank Citigroup Inc. as investment grade by the 2010 Dodd-Frank Act definition. Regular readers of these notes know that low default probabilities, per se, are not enough to make the bonds of a given issuer “good value.” How do Citigroup Inc. bonds rank among all other bonds by the ratio of credit spread to default probability? Citigroup Inc. bonds rank in the top third of all bonds traded on September 30 by our “best value” criterion. Only 66 of 251 heavily traded bonds on September 30, 2014 offered better value than the best value Citigroup Inc. bond.
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.
Copyright ©2014 Donald van Deventer