We first looked at the bond market perspective on Verizon Communications Inc. (VZ) on September 10, 2013. Just today, T-Mobile US, Inc. (TMUS) agreed to pay Verizon Communications Inc. $2.365 billion in a "spectrum swap" as the major service providers battle for market share in the United States. Verizon Communications Inc. agreed on September 2, 2013 to buy out the Vodafone Group PLC (VOD) interest in the company's U.S. wireless business. At that time, the marketing process for a Verizon Communications Inc. bond issue estimated at $25 billion was underway. In this note we re-examine the risk and return trade-off for the bonds of Verizon Communications Inc. Today's study incorporates Verizon Communications Inc. bond price data as of January 3, 2014. A total of 255 trades were analyzed on 22 fixed-rate non-call bond issues of Verizon Communications Inc. with trading volume of $96.3 million. We omitted data on one bond issue for which reported trade information was obviously in error. We leave for another day an analysis of spread on the bonds of various regional subsidiaries of Verizon Communications Inc.
We reach two important conclusions. First, we again believe that Verizon Communications Inc. would be judged "investment grade" by a majority of analysts. Our second conclusion is the opposite of our judgment in September. From an investor value perspective, we look at the ratio of credit spread to default probability. By this measure, Verizon Communications Inc. bonds now offer below average value, compared to the above-average value indicated by market prices in September. We explain our conclusions in what follows.
Verizon Communications Inc. Analysis
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 analyze the maturities where the credit spread/default probability ratio is highest for Verizon Communications Inc. We also assess the likelihood that a sophisticated analyst would define Verizon Communications Inc. as "investment grade" in light of the revised definition of that term triggered by the Dodd-Frank legislation defined below.
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 Verizon Communications Inc. ranging from one month to 10 years on an annualized basis. We also display the default probabilities for September 9, 2013 used in our prior analysis. 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 0.06% at one month (unchanged from September) to 0.03% at 1 year (down 0.01% from September) and 0.43% at ten years (up 0.03% from September). The green line represents the current default probabilities and the yellow line graphs the September 9 values.
We 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 the bond data mentioned above for the Verizon Communications Inc. fixed rate non-call bond issues.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Verizon 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 Verizon Communications 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 line from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on Verizon Communications 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 Verizon Communications Inc. issue recorded by TRACE. The black line and black dots represent the best fitting Verizon Communications Inc. bond yields on a trade-weighted basis.
The liquidity premium built into the yields of Verizon 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) generally widens as the maturity of the underlying bonds increases.
The high, low and average credit spreads at each maturity are graphed below. Again, we see 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 trade volume-weighted cubic polynomial that explains the average spread as a function of years to maturity. This polynomial explains 98.7% 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 Verizon Communications Inc. For maturities under 3 years, the average credit spread to default probability ratio is 3 to 10 times. The ratio of average credit spread to default probability decreases beyond that, generally ranging between 1.8 and 3.8 times. This reward to risk ratio has been cut in half since the September analysis. The drop in the credit spread to default probability ratio has taken Verizon Communications Inc. bonds from "above average" to below average compared to other bonds in the market place.
The reward to risk ratios reported in September are reproduced here:
The credit spread to default probability ratios are shown in graphic form here.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended December 27, 2013 (the most recent week for which data is available), the credit default swap trading volume on Verizon Communications Inc. was 8 trades with $91.5 million of notional principal. The number of credit default swap contracts traded on Verizon Communications Inc. in the 155 weeks ended June 28, 2013 is summarized in the following table:
Verizon Communications Inc. ranked 161st among all reference names in weekly credit default swap trading volume during this period, which is graphed below:
On a cumulative basis, the default probabilities for Verizon Communications Inc. range from 0.03% at 1 year (down 0.01% from September, shown in yellow) to 4.24%% at 10 years (up 0.35% since September).
Over the last decade, the 1 year and 5 year default probabilities for Verizon Communications Inc. have been volatile, but neither the 1 year default probability nor the 5 year default probability have exceeded 0.60% in the last decade. (click to enlarge)
In contrast to the daily movements in default probabilities graphed above, the legacy credit ratings, those reported by credit rating agencies like McGraw-Hill unit Standard & Poor's and Moody's, for Verizon Communications Inc. have changed only three times during the decade, somewhat more slowly 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 Verizon Communications 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 Verizon Communications Inc. default risk responds to changes in the following factors among those listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review:
- 10 year U.S. Treasury yields
- Home price index
These macro factors explain 26.7% of the variation in the default probability of Verizon Communications Inc. The remaining volatility is the idiosyncratic risk of Verizon Communications Inc. as it battles for market share in the United States.
Verizon Communications Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the USA "telecom services" sector, Verizon Communications Inc. has the following percentile ranking for its default probabilities among its 65 peers at these maturities:
1 month 48th percentile, up 5 points since September
1 year 17th percentile, unchanged
3 years 9th percentile, down 2 points since September
5 years 6th percentile, up 1 point since September
10 years 5th percentile, unchanged since September
The percentile ranking of Verizon Communications Inc. default probabilities at three years through ten years is in safest decile of the peer group. Taking another view, both the actual and statistically predicted Verizon Communications Inc. credit ratings are "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 one notch above the legacy rating.
Before making an assessment of whether or not Verizon Communications is "investment grade" as redefined by Dodd-Frank, we look at the market's perspective.
Credit spreads for Verizon Communications Inc. are plotted here versus traded credit spreads on January 3 in the "technology, media and telecommunications" sector.
The good news from a credit risk perspective is that Verizon Communications Inc. credit spreads are at or below peer levels. We discuss what that means from an investor value perspective below.
The next graph plots Verizon Communications Inc. matched-maturity default probabilities versus matched-maturity default probabilities on bonds traded on January 3, 2014 in the same industry sector.
By this measure, the default probabilities for Verizon Communications Inc. are approximately equal to the traded peer group on January 3, 2014. Note the contrast with the percentile ranks given above. What this means is that the best credits in the sector are being traded and the weaker credits are not traded, because Verizon's percentile rank is much lower among the traded peers.
We now compare the credit spreads on Verizon Communications Inc. versus the credit spreads of investment grade firms in all industry sectors whose bonds were traded on January 3, 2014. We show that comparison here:
Verizon Communications Inc. credit spreads are slightly below the median for investment grade bonds traded on January 3, 2014 for short maturities and near the median at longer maturities. The next chart makes the same comparison for default probabilities for Verizon Communications Inc. versus investment grade firms whose bonds traded on January 3, 2014:
This graph again makes it clear that the investment grade firms that were traded on January 3, 2014 are a stronger group that the full investment grade peer group. By this comparison, Verizon Communications Inc. default probabilities are at or above the median.
In light of this data, we believe the overwhelming majority of analysts would rate Verizon Communications Inc. as investment grade. This conclusion is unchanged from September. From an investor value perspective, however, our conclusions have changed significantly. We measure value by the ratio of credit spread to default probability. In September, in the midst of the very large Verizon bond issue, Verizon Communications Inc. bonds offered better than average value, as summarized by the spread to default ratios shown in the chart reproduced above. As of January 3, 2014, however, spreads have tightened and long term default probabilities have risen on Verizon Communications Inc. bonds. Investors seeking to maximize the ratio of credit spread to default probabilities on their bond investments can now easily find better value in the bonds of other issuers.
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 Seeking Alpha, 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.
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.
Background on the Dodd-Frank Act and the Meaning of "Investment Grade"
Section 939A of the Dodd-Frank Act states the following:
"SEC. 939A. REVIEW OF RELIANCE ON RATINGS.
(A) AGENCY REVIEW.-Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review-
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(B) MODIFICATIONS REQUIRED.-Each such agency shall modify any such regulations identified by the review conducted under subsection to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(C) REPORT.-Upon conclusion of the review required under subsection , each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection .
The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:
"In this rulemaking, the OCC has amended the regulatory definition of 'investment grade' in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is 'investment grade,' banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution's risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised 'investment grade' standard."
Additional disclosure: Kamakura Corporation has business relationships with a number of firms mentioned in the article.