We last analyzed AT&T Inc. (NYSE:T) on December 16, 2013 using bond price data from December 13. AT&T Inc. is attractive to many analysts and investors because the current dividend yield is more than 5 percent. At the same time, AT&T Inc. is dealing with on-going upheavals in the telecommunications industry and is surrounded by rivals who are both aggressive and highly risky from a credit risk perspective. In this note, we update our bond market perspective on AT&T Inc. and ask this question: how much of the dividend yield of AT&T Inc. is due to the credit risk of the firm?
Conclusion: We believe a strong majority of analysts would rate AT&T Inc. as investment grade under the new definition required by the Dodd-Frank Act. The credit spread to default probability ratio for AT&T Inc., however, is well below average. On April 22, 302 of 377 heavily traded bond issues provided better value by this measure than any AT&T Inc. bond issue. The 5.24% dividend yield on AT&T Inc. common stock includes a premium of 0.89% for the relatively high long-term credit risk of the firm.
Today's study incorporates AT&T bond price data as of April 22, 2014. A total of 386 trades were reported on 25 fixed-rate non-call bond issues of AT&T with trade volume of $106.2 million.
The purpose of this note is to answer three simple questions:
- Are the bonds of AT&T Inc. "good value" relative to other bonds available in the market place?
- In light of the new definition of investment grade required by the Dodd-Frank Act, how would most analysts classify AT&T Inc., as investment grade or not?
- What would the dividend yield be if AT&T Inc. had no credit risk?
Assuming the recovery rate in the event of default would be the same on all bond issues for the same issuer and same seniority, 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 to default probability ratio is highest for AT&T 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 (green line) shows the current default probabilities for AT&T Inc. ranging from one month to 10 years on an annualized basis. We assume that default probabilities for maturities over ten years are equal to 10 year default probabilities. The yellow line graphs the same default probabilities as of December 13, 2013. The default probabilities range from 0.12% at one month (down 0.07% from December) to 0.06% (down 0.04%) at 1 year and 0.61% at ten years (up 0.04%).
We explain the source and methodology for the default probabilities in nearly every post we make on SeekingAlpha in the Instablog section.
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 25 AT&T Inc. fixed rate non-call senior debt issues in this analysis.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of AT&T 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 AT&T 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 AT&T Inc. bonds. The fourth line from the bottom (the green dots) displays the trade-weighted average yield reported by TRACE on the same day. The highest yield (the red dots) is obviously the maximum yield in each AT&T Inc. issue recorded by TRACE. The black dots and connecting black line represent the trade-weighted yield curve that best fits the credit spreads observed for AT&T Inc. on April 22, 2014.
The data makes it clear that there is a liquidity premium built into the yields of AT&T 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 are very narrow for short maturities. They widen significantly for maturities of 10 years and longer. A regular reader of this series of notes may notice that the ratio of credit spread to default probability for AT&T Inc. is narrower than normal. We document that fact in the rest of this note.
The high, low and average credit spreads at each maturity are graphed below, along with the trade-weighted credit spreads consistent with a cubic polynomial on April 22. Credit spreads are generally increasing with the maturity of the bonds for most issuers. 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 average spread as a 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. This ratio of spread to default probability is shown in the following table for AT&T Inc. At almost all maturities under 3 years, the reward from holding the bonds of AT&T Inc., relative to the matched maturity default probability, is between 2 and 5 basis points of credit spread reward for every basis point of default risk. The ratio of spread to default probability decreases once the maturity of the bonds exceeds 3 years, falling to a spread to default ratio between 1 and 3 times. This reward to risk ratio is among the lowest of any firm analyzed in this series of bond studies. We quantify that statement using 377 bond issues that traded heavily on April 22, 2014 below.
Many readers have requested that we add CUSIP identifiers to this chart. Ironically, even though CUSIPs for many AT&T Inc. bond issues can be found with an internet search, it is illegal for me or my firm to publish CUSIP identifiers under the contract with the supplier of TRACE bond price data.
The same spread to default probability ratios for AT&T Inc. on December 13, 2013 are shown here:
The credit spread to default probability ratios are shown in graphic form in the chart below. We have again added a polynomial function relating the credit spread to default probability ratio to the years to maturity on the underlying bonds.
How do the credit spread to default probability ratios for AT&T Inc. bonds compare with other bonds traded in the market place on April 22, 2014? To answer that question, we isolated all senior fixed-rate non-call debt issues with daily trading volume of at least $5 million and a maturity of one year or longer on April 22, 2014. A histogram of credit spreads on those 377 bonds is shown here:
The median credit spread was 0.824% and the average credit spread was 1.132%. The median credit spread to default ratio was 7.425, more than double the levels found for the longest maturities of AT&T Inc. bonds. The average credit spread to default probability ratio was 10.80. The distribution of the credit spread to default probability ratios (capped at 40 times) is shown in this graph:
Six of the AT&T Inc. bond issues had trading volume of more than $5 million, so they are included in the universe of 377 bonds. The best ranking AT&T bond was only 303rd among the 377 bonds when ordered from best to worst credit spread to default probability ratio. The remaining AT&T Inc. bonds ranked 305, 320, 353, 357, and 358 as shown in this chart.
Credit-Adjusted Dividend Yield
We explained in a recent post on General Electric Company (NYSE: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 AT&T 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:
The widening of zero coupon credit spreads, as we shall see below, comes about because the longest maturity bond issues of AT&T were lightly traded, distorting the credit spread a bit. If we discount dividend payments for maturities of 1, 10 and almost 30 years, we can solve for the "credit risk free" dividend for AT&T 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 AT&T Inc. over almost 30 years. We use this data from SeekingAlpha.com:
Readers who prefer a real time update of this information can see that here. After discounting the flow of dividends from AT&T Inc. at their current quarterly rate of $0.46 and using the present value factors implied by AT&T Inc. bond prices, we find that the long term credit-adjusted dividend yield is 4.35%, 0.89% less than the traditional dividend yield of 5.24% (note that the yield on the SeekingAlpha website is different because of lags in updating the figure as the stock price changes). Both calculations assume that the current dividends remain at their current level forever, except in the credit-adjusted case we recognize that AT&T Inc. may default, ending the dividend stream. The bond-based discount factors recognize this fact. We show the calculation below for just the first 12 months of cash flows. We turn to the bond discount factors now.
Credit Default Swap Market Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended April 18, 2014 (the most recent week for which data is available), the trading volume for credit default swaps on AT&T Inc. was notional principal of $51,000,000 in 6 contracts, far less than the trading volume in the U.S. market for AT&T Inc. bonds. The graph below shows the number of credit default swap contracts traded on AT&T Inc. since DTCC began its weekly releases of trading volumes in July 2010.
The notional principal on credit default swaps traded on AT&T Inc. are shown here:
On a cumulative basis, the current default probabilities (shown in green) for AT&T Inc. range from 0.06% at 1 year (down 0.04% from December, shown in yellow) to 5.95% at 10 years (up 0.38% from December and up 0.80% from August), as shown in the following graph.
Over the last decade, the 1 year and 5 year default probabilities for AT&T Inc. have varied as shown in the following graph. The one year default probability peaked at just under 0.60% in the first half of 2009 during the worst part of the credit crisis. The 5 year default probability (annualized) peaked near 0.60% in 2005. The default probability history for AT&T Inc. is striking for two reasons. First, the peak in default probabilities is well below that of many well-known banks and industrial firms during the credit crisis. That's the good news. The bad news is that the volatility of the default probabilities has not abated as the credit crisis recedes into history. That is due to the on-going disruption in the telecommunications industry. The five year annualized default probability has been climbing steadily for the last 3 years, consistent with the rise in cumulative default probabilities explained above.
The macro-economic factors driving the historical movements in the default probabilities of AT&T 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 complicated for AT&T Inc. and its competitors as the fundamental technology used in the telecommunications sector is undergoing a complete upheaval. With that caveat, the historical analysis shows that AT&T Inc. default risk responds to changes in 6 macro factors among those listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 48.4% of the variation in the default probability of AT&T Inc., a much lower than average percentage because technology factors have dominated in the determination of the firm's credit risk. The remaining 51.6% of total default risk of AT&T Inc. is idiosyncratic risk of the firm.
AT&T Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the USA "telecom services" sector, AT&T Inc. has the following percentile ranking for its default probabilities among its 64 rated peers at these maturities:
1 month 59th percentile
1 year 23rd percentile
3 years 13th percentile
5 years 8th percentile
10 years 8th percentile
The percentile ranking of AT&T Inc. default probabilities at one month is in the riskiest half of the telecom services peer group. The percentile ranking for AT&T Inc. at 5 and 10 years is in the safest decile of credit risk among telecom services firms. This reflects the market prices of the firm's common stock and bonds, with investors betting that the firm is a long-term survivor in the telecommunications sector with declining relative risk as time goes on. That being said, the peer comparison with the risky telecom sector is favorable for AT&T Inc. mainly because the entire sector has higher default probabilities than the average industrial firm.
Taking still another view, both the actual and statistically predicted AT&T Inc. credit ratings are "investment grade" by traditional credit rating standards of Moody's Investors Service (NYSE:MCO) and the Standard & Poor's affiliate of McGraw-Hill (MHFI). The actual and statistically predicted rating are at the same level. In contrast to the daily movements in default probabilities graphed above, the legacy credit ratings for AT&T Inc. have changed only twice during the last decade.
Our focus in this series of articles is not on the opinion of this analyst. In order to meet the requirements of the new Dodd-Frank definition of investment grade, explained in our December post on Citigroup (NYSE:C), we focus on facts. Indeed, the focus is on the opinion of market participants as implied by bond prices, credit spreads and default probabilities. In order to learn more about the opinions of market participants, we first plot the credit spreads of AT&T Inc. against the "technology, media and telecommunications" peer group credit spreads as of April 22:
AT&T Inc. credit spreads are slightly below the mid-point of the credit spreads for the peer group. We now turn to a comparison with the matched maturity default probabilities for the peer group on the same day:
Here, the comparison is not as favorable, with AT&T Inc. default probabilities ranging above the mid-point of the peer group.
We now compare trading in the bonds of AT&T Inc. with the traded credit spreads of bonds with a legacy "investment grade" rating from the rating agencies:
By this measure, AT&T Inc. is solidly in the middle of the pack, although it is probably above the median at the longer maturities. When we compare the default probabilities of AT&T Inc. with the matched maturity default probabilities of investment grade firms whose bonds traded on April 22, we get the following comparison:
AT&T Inc. default probabilities are strikingly above the median for the investment grade peer group, particularly at the longest maturities.
As we said in August and December studies, AT&T Inc. is a complex credit. While the long-term peer group comparison places the firm in the best decile of peer group credit risk, the entire telecommunications sector faces a constantly changing technological landscape and a higher than average level of default risk. This is reflected in a high degree of volatility for ATT Inc. default probabilities even though they have remained well below the 1% level at which the Kamakura Troubled Company Index labels a firm as "troubled." In spite of this concern, we believe a strong majority of analysts would define AT&T Inc. as investment grade. Note that our own views on the quality of the credit are explicitly given in the first part of this paper where we state the default probabilities for the firm. We discuss the "investment grade" analysis like a political poll, for the same reason polling is used in politics: "investment grade" involves complex perceptions of the analyst, parallel to perceptions of presidential candidates, even when everyone has identical information. The percentage ranking for "investment grade" is not 100% for any firm, just as no candidate for President of the United States has received 100% of the vote.
Even though the default probabilities of AT&T are relatively low, the ratio of the credit spreads to default probabilities for the firm are very low across the board. The attractiveness of the AT&T name and the firm's status as an icon of American industry comes with a price. All other things being equal, investors in the bonds of AT&T receive much less reward (in terms of credit spread) relative to the risk they are taking (in terms of default probabilities) compared to the bonds of other issuers. When looking at dividends, the 5.24% traditional dividend yield on AT&T Inc. stock includes a credit risk premium of 0.89% over the 4.35% dividend yield of a risk-free issuer that promises the same present value of dividends as AT&T Inc. over a time horizon near 30 years. The credit-risk-adjusted dividend yield on AT&T Inc. is this 4.35% figure.
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.