In this analysis, we take a second look at Anheuser-Busch InBev S.A. (NYSE:BUD) from a bond market perspective, updating our analysis published on October 6, 2013. Anheuser-Busch InBev S.A. is one of the world's five largest consumer products companies and one of the most truly international organizations in the world. The Anheuser-Busch InBev S.A. annual report explains the firm's world-wide product line in detail. Analysts of the company, as usual, have been both pro and con. In this note, we turn to the bonds issued through subsidiary Anheuser Busch InBev Worldwide Inc. These bonds have the full and unconditional guarantee of the parent Anheuser-Busch InBev S.A. We seek to bring a bond market perspective to the outlook for Anheuser-Busch InBev S.A. as a complement to analysis based on a common stock holder's perspective. Today's note incorporates Anheuser Busch InBev Worldwide Inc. bond price data as of February 13, 2014. A total of 76 trades were reported on 11 fixed-rate non-call senior bond issues of Anheuser Busch InBev Worldwide Inc. with trading volume of $38.7 million. We used all of this data in this note. Trade data for other legal entities affiliated with the parent company traded on February 13 but we do not analyze them in this note.
Conclusion: We believe that a strong majority of analysts would rate Anheuser-Busch InBev S.A. as investment grade. Although the default probabilities of the firm are low and essentially unchanged from our prior report, the credit spread to default probability ratio on the firm's bonds is slightly below the median of all senior fixed rate non-call debt which traded on February 13. Investors seeking diversification, not just the maximum reward to risk ratio, are those best placed to invest in the firm's bonds.
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 Anheuser-Busch InBev S.A. 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 Anheuser-Busch InBev S.A.
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 green) for Anheuser-Busch InBev S.A. ranging from one month to 10 years on an annualized basis, compared to the same default probabilities on October 4, 2013 (in yellow). 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 0.01% at one month to 0.01% at 1 year and 0.13% at ten years. The three default probabilities are unchanged from October, although the term structure of default probabilities varies between those three maturity points.
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 11 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 Anheuser-Busch InBev S.A. 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 (NYSEARCA:TLT)(NYSEARCA:TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of the subsidiary Anheuser Busch InBev Worldwide 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 yield reported by TRACE on that day on Anheuser Busch InBev Worldwide Inc. bonds. The green dots display the value-weighted average yield reported by TRACE on the same day. The red dots represent the maximum yield in each Anheuser Busch InBev Worldwide Inc. bond issue recorded by TRACE. The black dots and connecting line represent the yield consistent with the fitted trade-weighted credit spread described below.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Anheuser Busch InBev Worldwide Inc. This 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 Anheuser Busch InBev Worldwide 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 trade-weighted cubic polynomial that explains the trade-weighted average spread as a function of years to maturity. The polynomial explains 76.09% of the variation in credit spreads over the maturity spectrum.
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 Anheuser-Busch InBev S.A. and Anheuser Busch InBev Worldwide Inc., the credit spread to default probability ratio ranges from more than 18 times at maturities under 2 years to a range from 6.8 to 9.7 times at longer maturities. The ratios of spread to default probability for all traded bond issues on February 13, 2014 are shown here:
For the longer maturities, the credit spread to default probability ratios are slightly narrower than we found on October 4. The same analysis from October 4, 2013 is repeated here:
The credit spread to default probability ratios on February 13, 2014 are shown in graphic form below for Anheuser-Busch InBev S.A. and Anheuser Busch InBev Worldwide Inc.
How does the reward to risk ratio for Anheuser Busch InBev Worldwide Inc. compare to other bonds that traded on February 13, 2014? We first look at the distribution of credit spreads (in percent) on February 13, 2014 for all senior fixed rate non-call debt issued that traded at least $5 million on that day:
Anheuser Busch InBev Worldwide Inc. credit spreads are near the median, 0.968%, for the trades that took place on February 13. More importantly, we look at the distribution of the ratios of credit spreads to default probabilities for the same group of bonds on February 13, 2014:
The median credit spread to default probability ratio on February 13, 2014 was 10.69, and the average credit spread to default probability ratio was 17.33 (the mean is skewed by the ratios for very low default probability bond issues). Anheuser Busch InBev Worldwide Inc. bonds have a reward to risk ratio slightly below the median of the 280 large trades on February 13, 2014. Which trades provided a better reward to risk ratio than Anheuser Busch InBev Worldwide Inc.? Here are the 30 best value trades with over 1 year to maturity with more than $5 million traded on February 13, 2014 among senior fixed rate non-call debt issues:
Analysis of Credit Default Swap Trading Volume
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended February 7, 2014 (the most recent week for which data is available), the credit default swap trading volume on Anheuser-Busch InBev S.A. was 2 trades for $5.4 million, well below the volume of bonds traded in just one day in the U.S. market. The weekly trading volume (number of contracts) for Anheuser-Busch InBev S.A. during 181 weeks ended December 27, 2013 is graphed here:
The weekly trading volume (U.S. dollar equivalent notional principal) for the 181 weeks ended December 27, 2013 is graphed here:
On a cumulative basis, the current default probabilities (in green) for Anheuser-Busch InBev S.A. range from 0.01% at 1 year to 1.27% at 10 years, up 0.02% from October (shown in yellow).
Over the last decade, the 1 year and 5 year annualized default probabilities for Anheuser-Busch InBev S.A. have remained at a low level that many of the largest financial institutions in the world would envy, with one brief exception. The 1 year default probability peaked at slightly over 1.50% in early 2009. The 5 year default probability peaked at slightly under 0.60% at the same time.
As explained at the end of 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 Anheuser-Busch InBev S.A. 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 Anheuser-Busch InBev S.A. default risk responds to changes in 4 domestic U.S. risk factors and 6 international risk factors among the 28 world-wide macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 93.2% of the variation in the default probability of Anheuser-Busch InBev S.A. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Anheuser-Busch InBev S.A. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the world-wide "food, beverage and tobacco" sector, Anheuser-Busch InBev S.A. has the following percentile ranking for its default probabilities among its 1,503 peers at these maturities:
1 month 41st percentile, up 2 points from October
1 year 22nd percentile, unchanged from October
3 years 13th percentile, up 2 points from October
5 years 13th percentile, up 1 point from October
10 years 10th percentile, unchanged
The short term ranking of Anheuser-Busch InBev S.A. relative to its peers is higher simply because business conditions are so good currently that they rank at the 98th percentile for the period from 1990 to the present. The strong corporate business conditions drive the default probabilities of all firms to low levels. Over a longer time horizon, Anheuser-Busch InBev S.A. ranks in the safest quintile of its peer group from a credit risk perspective. Taking still another view, the actual and statistically predicted Anheuser-Busch InBev S.A. credit ratings both show a rating strongly in the "investment grade" territory. The statistically predicted rating is 1 notch below the legacy rating from firms like the Standard & Poor's affiliate of McGraw-Hill (NYSE:MHFI) and Moody's Investors Service (NYSE:MCO). Legacy ratings have changed only twice since 2008.
Before opining on whether Anheuser-Busch InBev S.A. is "investment grade" by the modern definition of that term, we look at the market's opinion in additional depth. On February 13, bond trades of the company's industry sector peers can be compared with credit spreads for Anheuser-Busch InBev S.A.:
The company's financing vehicle Anheuser Busch InBev Worldwide Inc. had credit spreads on February 13 very similar to the median of the industry sector peer group. The matched maturity sector peer default probabilities are compared to those for Anheuser-Busch InBev S.A. in this graph:
The default probabilities are at the low (GOOD) end of the industry sector peer group. Now we turn to February 13 bond trades of the investment grade (using the "legacy" ratings-based definition) peer group. We compare credit spreads first:
Credit spreads for Anheuser Busch InBev Worldwide Inc. are at the low end of the investment grade peer group. Comparing investment grade matched-maturity default probabilities, we also find the company at the low end of the investment grade peer group.
We believe that a very strong majority of sophisticated analysts would rank Anheuser-Busch InBev S.A. as an investment grade company. We note that no candidate for President of the United States has ever won 100% of the popular vote, which is one reason why our informal assessment of the opinions of a large number of analysts never states that there is a unanimous opinion. Such a statement would be unprovable and extremely unlikely to be true in any event. The long run default probability outlook of Anheuser-Busch InBev S.A. ranks in the best quintile of its peer group, and default probabilities have varied in a narrow band over the last decade. We remind readers that a below average default probability is not sufficient reason to buy a bond. The bond must offer "good value," which we define in terms of the ratio of credit spread to the matching maturity default probability. By this measure, Anheuser-Busch InBev S.A. bonds offer a reward to risk ratio that is slightly narrower than that for all bonds which traded at least $5 million on February 13. This does not put Anheuser-Busch InBev S.A. bonds into the "warm beer" category. It does mean, however, that investors should have another objective in mind, such as diversification, when buying the bonds because the credit spread to default probability ratio alone is slightly below average.
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.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.