Sprint Corporation (NYSE:S) is one of the most complex credits in the world, even compared to General Electric Capital Corporation, which we reviewed on September 4, 2013. Sprint Communications, Inc., the former Sprint Nextel Corporation, is now a subsidiary of parent Sprint Corporation, which in turn is 78% owned by SoftBank Corporation (OTCPK:SFTBY)(OTCPK:SFTBF) of Japan and its affiliates. We summarize the corporate ownership below using SEC filings. This note uses the default probabilities of Sprint Corporation and bond credit spreads of Sprint Communications, Inc. to measure the reward-to-risk ratio on the company's bonds. The recent transaction with Softbank has impacted the formerly transparent structure of the guaranty by the former parent Sprint Nextel Corporation of the debt of affiliates and subsidiaries. Today's study incorporates Sprint Communications, Inc. bond price data as of September 6, 2013. A total of 171 trades were reported on 5 fixed-rate non-call bond issues of Sprint Communications, Inc. with trading volume of $137.5 million. All of this data was used in this study. We leave for another day an analysis of spread on one bond of Sprint Corporation and 3 bonds of Sprint Capital Corporation observable in the market place.
The 10-Q filing by Sprint Corporation with the Securities and Exchange Commission for the quarter ended June 30, 2013 describes the legal structure in light of the Softbank investment as follows:
"On July 10, 2013, SoftBank Corp., a kabushiki kaisha organized under the laws of Japan, and certain of its wholly-owned subsidiaries (together, "SoftBank") completed the merger contemplated by the Merger Agreement (SoftBank Merger). As a result of the SoftBank Merger, SoftBank owns approximately 78% of the outstanding voting common stock of Sprint Corporation (formerly known as Starburst II, Inc. prior to the consummation of the SoftBank Merger), Sprint Corporation became the parent company of Sprint Nextel Corporation and Sprint Nextel Corporation changed its name to Sprint Communications, Inc."
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 Sprint Communications, Inc. to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which requires that credit rating references be eliminated. The new rules delete references to legacy credit ratings and replace them with default probabilities as explained here.
Assuming the recovery rate in the event of default would be the same on all bond issues, 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 Sprint Communications, Inc. Prior to the merger with SoftBank and its affiliates, the 10-Q for June 30, 2013 describes the credit support for bonds used in this study as follows:
"As of June 30, 2013, Sprint Nextel Corporation, the parent corporation, had $16.9 billion in principal amount of debt outstanding, including amounts drawn under the credit facilities. In addition, as of June 30, 2013, $6.8 billion in principal amount of our long-term debt issued by 100% owned subsidiaries was fully and unconditionally guaranteed by the parent. The indentures and financing arrangements governing certain subsidiaries' debt contain provisions that limit cash dividend payments on subsidiary common stock. The transfer of cash in the form of advances from the subsidiaries to the parent corporation generally is not restricted. Cash interest payments, net of amounts capitalized of $28 million and $217 million, totaled $808 million and $573 million during the six-month periods ended June 30, 2013 and 2012, respectively."
Important Note: The author has not reviewed legal documents stating the nature of the guaranty, if any, provided by Sprint Corporation in respect of bonds issued by Sprint Communications, Inc. and other affiliates. Any legal or moral obligations by SoftBank to support Sprint Corporation and Sprint Communications, Inc. debt should be thoroughly investigated by a potential investor, whether institutional or retail. As described here, the author spent 11 years in Japan in constant communication with financial institutions in Japan. The author's experience was that lenders in Japan were much less careful with inside information than their peers in other countries. Any potential investor should assume that market participants with a Tokyo office will be aware of SoftBank's intentions with respect to Sprint Corporation and Sprint Communications, Inc. even if those intentions have not been made "public" in a Western sense.
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. Kamakura Risk Information Services has an actively used non-public firm default probability model for non-public firms like Sprint Communications, Inc. In this note, however, we focus instead on the default probabilities of the parent company Sprint Corporation in light of the discussions above. The graph below shows the current default probabilities for Sprint Corporation ranging from one month to 10 years on an annualized basis. The default probabilities range from 1.46% at one month to 1.59% at 1 year and 5.58% at ten years.
We explain the source and methodology for the default probabilities below. The default probability term structure for SoftBank is given in this graph. We present this data without any insinuations that there is an implicit guaranty by SoftBank of the debt of Sprint Corporation and Sprint Communications, Inc. Indeed, as explained below, the bonds of Sprint Communications, Inc. are trading as if there is no such assumption at all by market participants. The SoftBank default probabilities range from 0.02% at 1 month and 0.01% at 1 year to 0.42% at 10 years, very significantly lower than those of Sprint Corporation.
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 the bond data mentioned above for 171 Sprint Communications, Inc. fixed rate non-call issues in this analysis.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Sprint Communications, 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 Sprint Communications, Inc. The second 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 Sprint Communications, Inc. bonds. The green line displays the average yield reported by TRACE on the same day. The red line is the maximum yield in each Sprint Communications, Inc. issue recorded by TRACE.
The liquidity premium built into the yields of Sprint Communications, Inc. above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm) becomes negative at maturities of 7 years and beyond. This is the first time in this series of bond analyses that this phenomenon has been observed.
The high, low and average credit spreads at each maturity are graphed below. Credit spreads are generally increasing with the maturity of the bonds. 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 that explains the average spread as a function of years to maturity. This polynomial explains 93.35% of the variation in the average credit spread over the maturity term structure:
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 Sprint Communications, Inc. using the very important and optimistic assumption that the default probabilities of Sprint Communications, Inc. are equal to those of Sprint Corporation. For maturities under 4 years, the credit spread to default probability ratio is about 1.5 times. The ratio of spread to default probability decreases beyond that, falling to a spread to default ratio that is less than one. This reward to risk ratio is the lowest of any firm analyzed in this series of bond studies, even though we are using the optimistic assumption that Sprint Communications, Inc. is no more risky than Sprint Corporation. Assuming the default probabilities are correct, investors in the long-term bonds of Sprint Communications, Inc. receive negative compensation for default risk unless there is a substantial recovery in the event of default.
The credit spread to default probability ratios are shown in graphic form here. We have again added a cubic polynomial relating the credit spread to default probability ratio to the years to maturity on the underlying bonds. The smoothed line explains 94.39% of the variation in the reward to risk ratio.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended August 30, 2013 (the most recent week for which data is available), the credit default swap trading volume on Sprint Communications, Inc. was 22 trades with $59.6 million of notional principal, a small fraction of the daily bond trading volume on September 6. The number of credit default swap contracts traded on Sprint Communications, Inc. in the 155 weeks ended June 28, 2013 is summarized in the following table:
Sprint Communications, Inc. ranked 27th among all reference names in weekly credit default swap trading volume during this period, which is graphed below:
For the week ended August 30, 2013, credit default swap trading for SoftBank Corporation was a mere 2 trades for $11.7 million in notional principal. For the 155 weeks ended June 28, 2013, trading volume for SoftBank Corporation was as follows:
Weekly trading volume for SoftBank Corporation is graphed below:
On a cumulative basis, the default probabilities for Sprint Corporation, the parent, range from 1.59% at 1 year to 43.69% at 10 years, a very high cumulative default probability, as shown in the following graph.
We remind the reader that we make no insinuation that SoftBank Corporation will take any actions in support of the debt of its 78%-owned affiliate Sprint Corporation or its subsidiaries. We present the cumulative default probabilities for SoftBank merely for the reader's convenience. The one year cumulative default probability for SoftBank is 0.01% and the 10 year cumulative default probability is 4.14% as shown here:
Over the last decade, the 1 year and 5 year default probabilities for Sprint Corporation, the parent, have varied as shown in the following graph. The one year default probability peaked at just over 60.00% in the first half of 2009 during the worst part of the credit crisis. The five year default probability peaked at more than 25.00%.
Just as troubling is the recent increase in both default probabilities, as shown in this more detailed graph of the default probability movements for Sprint Corporation:
In contrast to the daily movements in default probabilities graphed above, the legacy credit ratings [those reported by credit rating agencies like McGraw-Hill (NYSE:MHFI) unit Standard & Poor's and Moody's (NYSE:MCO)] for Sprint Corporation have changed eight times during the decade, somewhat more often than the median 815 days since the last rating change for rated companies found in a recent study by Kamakura Corporation.
The macro-economic factors driving the historical movements in the default probabilities of Sprint Corporation, the parent, 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 Sprint Corporation default risk responds to changes in the following factors among those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
- Change in nominal gross domestic product
- 3 month U.S. Treasury bill rates
- 30 year fixed rate mortgage yields
- The Dow Jones stock price index
- The VIX volatility index
- Home price index
- Commercial real estate prices
- 8 international macro factors
These macro factors explain 86.3% of the variation in the default probability of Sprint Corporation, a higher than average.
Sprint Corporation, the parent, can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the US "telecom services" sector, Sprint Corporation has the following percentile ranking for its default probabilities among its 63 peers at these maturities:
1 month 89th percentile
1 year 81st percentile
3 years 78th percentile
5 years 62nd percentile
10 years 59th percentile
The percentile ranking of Sprint Corporation default probabilities at one month through three years is in the riskiest quarter of the peer group. The percentile ranking for Sprint Corporation at 5 and 10 years is in the riskiest half of peer firms. Taking still another view, both the actual and statistically predicted Sprint Corporation credit ratings are "non-investment grade" by traditional credit rating standards of Moody's Investors Service and the Standard & Poor's affiliate of McGraw-Hill. The statistically predicted rating is two notches above the legacy rating.
Sprint Corporation is a complex credit, even when viewed as if SoftBank did not own 78% of the company. Sprint Communications, Inc. bonds are high risk by any measure, with a cumulative probability of default over the next decade of 43.69%. We believe that few, if any, analysts would rate the firm as "investment grade." For those investors with a high tolerance for credit risk, the next question is a simple one: does one receive enough compensation for the high default risk of Sprint Communications, Inc. that the investment is worthwhile? In this case, the answer is a resounding "no" unless one makes the optimistic assumption that the 78% owner SoftBank will step in to prevent a bankruptcy. While this possibility is not zero, the true possibility is likely to be well-known to large institutional investors with a presence in Tokyo long before an official announcement of intent is made. This forecast is based on the author's long experience in the Tokyo market, a time when the author was frequently given inside information without even asking about such information. The forecast does not imply such information would come from the company itself. On the contrary, it is much more likely to come from lenders to SoftBank. For all of these reasons, we recommend that investors avoid the bonds of Sprint Corporation and its affiliates until there is an explicit guaranty from SoftBank Corporation itself or until the spread move more in line with the estimated default probabilities.
Background on Default Probabilities Used
The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. An overview of the full suite of related default probability models is available here.
General Background on Reduced Form Models
For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.
Additional disclosure: Kamakura Corporation has business relationships with a number of firms mentioned in this article.