Prudential Financial Inc.: A Bond Market View

Conclusion: We believe the overwhelming majority of analysts would judge Prudential Financial Inc. to be investment grade by the new Dodd-Frank definition. We note that the firm has exceptionally low default probabilities. As always, we remind the reader that this alone is not sufficient grounds on which to invest in the bonds of the firm. The bonds must also provide good value, which we have measured by the ratio of the credit spread to the default probability. Prudential Financial Inc. is a rare instance of a brand name firm where the bonds still offer very attractive value. The bonds of Prudential Financial Inc. rank solidly in the top quartile of the value rankings for all bond issues that traded at least $5 million in volume on March 19, 2014.

The Analysis

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 Prudential Financial Inc. to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. 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/default probability ratio is highest for Prudential Financial 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 Prudential Financial Inc. 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 range from 0.01% at one month to 0.01% at 1 year and 0.06% at ten years. These default probabilities are exceptionally low for a major financial services firm.

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. We used all of the 21 bond issues mentioned above in this analysis.

The graph below shows 6 different yield “curves” that are relevant to a risk and return analysis of Prudential Financial 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 exactly matches the maturity of the traded bonds of Prudential Financial 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 dots graph the lowest yields reported by TRACE on that day on Prudential Financial Inc. 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 of the Prudential Financial Inc. issues 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 large and generally increasing “liquidity premium” as maturity lengthens for the bonds of Prudential Financial Inc. We explore this premium in detail below.

The high, low and average credit spreads at each maturity are graphed below for Prudential Financial Inc. 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 Prudential Financial Inc., the credit spread to default probability ratio generally ranges from about 12 on up for maturities of 4 years and under. For the longer maturities, the credit spread to default probability ratio falls in a range from 16 to 24 times. This is much higher than we have normally seen in this series of notes.

The credit spread to default probability ratios are shown in graphic form below for Prudential Financial Inc.

Are these reward to risk ratios “normal”? Are they above or below average? The best way to answer that question precisely 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 March 19. The distribution of the credit spreads on the 385 traded bonds that met these criteria on March 19 is first plotted in this histogram (only spreads of less than 8.00% are graphed):

The median credit spread for all 385 trades was 0.94%. The average credit spread was 1.16%. The next graph shows the wide dispersion of the credit spread to default probability ratios on those 385 March 19 trades (only ratios of 40 or less are graphed):

The median credit spread to default probability ratio on those 385 trades was 9.15 and the average credit spread to default probability ratio was 13.01. Prudential Financial Inc.’s credit spread to default probabilities are well above the average and the median. Only 50 out of 385 large trades on March 19 had better credit spread to default probability ratios than the best ratio for any of Prudential Financial Inc. bonds which traded at least $5 million in volume. Here are the 20 “best trades” done March 19, 2014 that had the highest ratios of credit spread to default probability. We have also reproduced the credit spread to default probability ratios for bond trades over $5 million in volume for Prudential Financial Inc. Prudential Financial Inc. bonds ranked 51st through 94^th of the 385 large trades on March 19. In short, Prudential Financial Inc. bonds were solidly in the top quartile of “best value” bond trades over $5 million on March 19, 2014.

Credit Default Swap Analysis

For the week ended March 14, 2014 (the most recent week for which data is available), the Depository Trust & Clearing Corporation reported there were 57 trades involving $180,709,882 in notional principal on Prudential Financial Inc. The weekly number of credit default swap trades on Prudential Financial Inc. since the DTCC began publicizing weekly trade volume is shown here:

The notional principal of credit default swap trading on Prudential Financial Inc. over the same period is shown in this graph:

Additional Analysis

On a cumulative basis, the default probabilities for Prudential Financial Inc. range from 0.01% at 1 year to 0.61% at 10 years. We give the relative rankings of the company’s default probabilities below. Compared to other firms reviewed in this series, these cumulative default probabilities rank among the lowest we have seen.

Over the last decade, the 1 year and 5 year annualized default probabilities for Prudential Financial Inc. have generally been very low, with the exception of the heart of the credit crisis. At the worst part of the crisis, the one year default probability rose almost to 10%, and the annualized 5 year default probability exceeded 2%. Default probabilities quickly resumed their low levels as the crisis passed.

As explained earlier in this note, the firm’s default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. 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 Prudential Financial 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. With that caveat, the historical analysis shows that Prudential Financial Inc. default risk responds to changes in 4 risk factors among the 28 world-wide macro factors used by the Federal Reserve in its2014 Comprehensive Capital Assessment and Review stress testing program, for which the results were announced today. These macro factors explain 87.4% of the variation in the default probability of Prudential Financial Inc. The remaining variation is the estimated idiosyncratic credit risk of the firm.

Prudential Financial Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the U.S. “insurance” sector, Prudential Financial Inc. has the following percentile ranking for its default probabilities among its 116 peers at these maturities:

1 month   34th percentile
1 year       34th percentile
3 years     52nd percentile
5 years     14th percentile
10 years   12th percentile

These percentile rankings are higher than one might expect, given the very low level of absolute default probabilities, simply because the insurance sector features some of the lowest default probabilities of any industry today. For the longer time horizons, Prudential Financial Inc. default probabilities are in the safest quintile of the peer group.

Comparison with Legacy Ratings

Taking still another view, the actual and statistically predicted credit ratings for Prudential Financial Inc. both show a rating solidly in the “investment grade” territory. The statistically predicted rating is one notch below the legacy rating, those of Moody’s (MCO) and Standard & Poor’s (MHFI). The legacy credit ratings of Prudential Financial Inc. have changed just three times in the last decade.

Conclusions

Before reaching a final conclusion about the “investment grade” status of Prudential Financial Inc., we look at more market data. First, we look at Prudential Financial Inc. credit spreads versus credit spreads on every bond in the “insurance” sector that traded on March 19:

Prudential Financial Inc. credit spreads were near the lower end of the range for the peer group. We now look at the matched maturity default probabilities on those traded bonds for both Prudential Financial Inc. and the peer group:

 

Consistent with the percentile rankings above, the default probabilities for Prudential Financial Inc. are at or below the average of the industry peer group. We note that the bonds trading heavily are generally a much better group of credits than the industry in aggregate. We now turn to the legacy “investment grade” peers. First we compare traded credit spreads on March 19, 2014:

Again, Prudential Financial Inc. credit spreads are solidly in the safest half of the investment grade peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on March 19 are shown in this graph:

Again the default probabilities for Prudential Financial Inc. rank as among the safest of the full traded investment grade peer group.

We believe the overwhelming majority of analysts would judge Prudential Financial Inc. to be investment grade by the new Dodd-Frank definition. We note that the firm has exceptionally low default probabilities. As always, we remind the reader that this alone is not sufficient grounds on which to invest in the bonds of the firm. The bonds must also provide good value, which we have measured by the ratio of the credit spread to the default probability. Prudential Financial Inc. is a rare instance of a brand name firm where the bonds still offer very attractive value. The bonds of Prudential Financial Inc. rank solidly in the top quartile of the value rankings for all bond issues that traded at least $5 million in volume on March 19, 2014.

Author’s Note

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.