Morgan Stanley (NYSE:MS) is both one of the world's most important financial institutions and one of the world's few survivors of a near-death experience in the financial crisis. In this note, we turn to the U.S. dollar bonds issued Morgan Stanley and compare its current default probabilities with those we reported on October 11, 2013. Like any forward-looking analysis, the history of the firm in question is an important aid to understanding Morgan Stanley's challenges during the crisis, and an analysis of daily credit crisis borrowings from the Federal Reserve were chronicled by Kamakura Corporation. In addition, Morgan Stanley received a $10 billion capital injection from the United States government as described in this October 5, 2009 report from the Special Inspector General of the Troubled Asset Relief Program. Morgan Stanley was also the beneficiary of the Temporary Liquidity Guarantee Program that supported financings of FDIC-insured institutions. Guarantees under this program were extended twice and expired December 31, 2012. Transactions by Morgan Stanley and others under this program are listed in this FDIC document.
With this history in mind, we seek to bring a bond market perspective to the outlook for Morgan Stanley as a complement to analysis based on a common stock holder's perspective. Today's note incorporates Morgan Stanley bond price data as of April 25, 2014. A total of 463 trades were reported on 65 fixed-rate non-call bond issues of Morgan Stanley with April 25 trading volume of $235 million.
Conclusion: We believe that a strong majority of analysts would rate Morgan Stanley as investment grade. We also note that the history of the firm from a default probability perspective is filled with drama. Morgan Stanley is a survivor in an increasingly concentrated securities business, one of the unexpected outcomes of the credit crisis. It offers above average ratios of credit spread to default probability compared to other firms traded on April 25. Finally, the credit-adjusted dividend yield on Morgan Stanley is 1.110% versus the traditional dividend yield calculation of 1.346%. The difference reflects the default risk of the firm and the associated risk aversion embedded in the bond prices of Morgan Stanley.
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 Morgan Stanley (which converted to a U.S. bank holding company in September 2008) to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. For a discussion of the implications of the Dodd-Frank Act on the definition of investment grade, see our post on Citigroup in December.
Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority for 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 Morgan Stanley.
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 Morgan Stanley (green line) ranging from one month to 10 years on an annualized basis. They are plotted versus the default probabilities for Morgan Stanley that we reported earlier for October 11, 2013 (orange line). For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The current Morgan Stanley default probabilities range from 0.11% at one month (down 0.04% since October 11, 2013) to 0.04% at 1 year (down 0.01%) and 0.17% at ten years (unchanged).
We also explain the source and methodology for the default probabilities in each Instablog posted here on Seeking Alpha.
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 issues mentioned above in this analysis.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Morgan Stanley 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 Morgan Stanley. 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 line graphs the lowest yield reported by TRACE on that day on Morgan Stanley bonds. The green line displays the value-weighted average yield reported by TRACE on the same day. The red line is the maximum yield in each Morgan Stanley bond issue recorded by TRACE.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Morgan Stanley, although the volatility of the data is high for Morgan Stanley. This increasing liquidity premium, except on the very long end of the curve, is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for Morgan Stanley. We have done nothing to smooth the data reported by TRACE (other than eliminating erroneous data as explained above), 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.
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 Morgan Stanley, the credit spread to default probability ratio ranges from 9 to 22 times at maturities under 2 years to a range from 8 to 15 times at longer maturities. The ratios of spread to default probability for all traded bond issues are shown here:
The same analysis as of October 11, 2013 is reproduced here:
The credit spread to default probability ratios are shown in graphic form below for Morgan Stanley.
Relative Value Analysis
How does the credit spread to default probability ratio for Morgan Stanley compare to other bonds available in the market place? Is it high, low or average? We answer that question by comparing the credit spread to default probability ratio for Morgan Stanley with all 303 bond issues with a daily trading volume of at least $5 million on April 25 and a maturity of 1 year or more. The first graph shows a histogram of the credit spreads that prevailed on these issues on April 25, 2014:
The median credit spread was 0.843% and the average was 1.089%. The distribution of the reward to risk ratio, the credit spread divided by the matched maturity default probability, is shown in the next histogram. The median ratio is 7.70 and the average ratio is 10.61.
The ratio of credit spread to default probability is shown in this chart for all of the Morgan Stanley bonds with at least $5 million in trading volume. One of the Morgan Stanley bonds, ranked 152, is the median credit spread to default probability ratio at 7.70. Eight of the Morgan Stanley bonds have a better spread to default probability ratios than the median, and 3 issues are below the median. Clearly skillful execution is very important in getting the maximum possible credit spread to default probability ratio on Morgan Stanley bonds.
For a recent ranking of heavily traded bonds with maturities of one year or more, please see this ranking from April 24, 2014.
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently prohibited by Kamakura Corporation's contract with the data vendor. We are working hard to change this so that we may make CUSIPs available in the future. In the meantime, CUSIPs for major issuers can be found easily with an internet such on web pages like this one from the New York Stock Exchange.
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 Morgan Stanley 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 is important. If we discount dividend payments for maturities of 1, 10 and almost 30 years, we can solve for the "credit risk free" dividend for Morgan Stanley. 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 Morgan Stanley over almost 30 years. We use this data from Seeking Alpha:
The history of Morgan Stanley dividends is nicely summarized on the NASDAQ website.
Readers who prefer a real time update of the dividend yield information can see that here. After projecting the flow of dividends from Morgan Stanley at the quarterly rate of $0.10 and using the present value factors implied by Morgan Stanley bond prices, we find that the long-term credit-adjusted dividend yield is 1.110%, 0.236% less than the traditional dividend yield of 1.346% (note that the yield on the Seeking Alpha website is different because of lags in updating the figure as the stock price changes). Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that Morgan Stanley may default, ending the dividend stream. The bond-based discount factors incorporate this fact. We show the calculation below for just the first 24 months of cash flows. We ignore the first (imminent) dividend payment and focus on the dividends that follow after that.
Credit Default Swap 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 credit default swap trading volume on Morgan Stanley was 19 trades for $162,647,598.
The notional principal traded weekly in the credit default swap market on Morgan Stanley is shown in this graph of data from the Depository Trust & Clearing Corporation:
The number of credit default swaps traded weekly on Morgan Stanley is shown in this history graph:
On a cumulative basis, the current default probabilities (in green) for Morgan Stanley range from 0.05% at 1 year (down 0.01% from October 11) to 1.70% at 10 years (down 0.04% from October). The October 11, 2013 cumulative default probabilities are graphed in orange.
Over the last decade, the 1 year and 5 year annualized default probabilities for Morgan Stanley spiked during the credit crisis as documented in the Kamakura Corporation study on Fed borrowings by Morgan Stanley given in the link above. The 1 year default probability peaked at slightly over 8% in 2008-2009. The 5 year default probability peaked at slightly over 2% on an annualized basis 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 Morgan Stanley 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 Morgan Stanley default risk responds to changes in 4 risk factors among the macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 77.4% of the variation in the default probability of Morgan Stanley. The remaining 22.6% of total variation is the estimated idiosyncratic credit risk of the firm.
Morgan Stanley can be compared with its peers in the same industry sector, as defined by Morgan Stanley itself and reported by Compustat. For the US "diversified financials" sector, Morgan Stanley has the following percentile ranking for its default probabilities among its 224 peers at these maturities:
1 month 84th percentile, unchanged since October
1 year 68th percentile, down 6 since October
3 years 54st percentile, down 7 since October
5 years 31st percentile, down 1 since October
10 years 28th percentile, down 1 since October
The short-term ranking of Morgan Stanley relative to its peers is higher because business conditions are so good currently that they rank at the 99th 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, Morgan Stanley ranks in the safest one-third of its peer group from a credit risk perspective.
Taking still another view, the actual and statistically predicted Morgan Stanley credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is 2 notches below the legacy rating from firms like the Standard & Poor's affiliate of McGraw-Hill (MHFI) and Moody's Investors Service (NYSE:MCO). The legacy ratings of the company have changed only 5 times in the last decade, in spite of the need for the U.S. government to inject $10 billion of capital into the firm.
We postpone our conclusions briefly to view some more facts. The "Banks/Finance" peer credit spreads on April 25 are shown here in light blue, with Morgan Stanley credit spreads plotted in dark blue. Morgan Stanley credit spreads are roughly in the middle of the pack.
The matched maturity default probabilities for the "Banks/Finance" peer group with bonds traded on April 25 are shown in this graph:
Again, Morgan Stanley is roughly in the middle of the peer group by this measure. Investment grade credit spreads on all bonds traded on April 25 are shown here in light blue with Morgan Stanley credit spreads plotted in dark blue:
Again, Morgan Stanley falls near the middle of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus Morgan Stanley:
The scale of the graph makes viewing difficult but Morgan Stanley is again near the middle of the pack.
We believe that a strong majority of analysts would rate Morgan Stanley as investment grade. We also note that the history of the firm from a default probability perspective is filled with drama. Many will debate whether the home price and mortgage market disaster that triggered the credit crisis can happen again. We remind the reader that the vast majority of observers of U.S. home price data prior to mid-2006 denied that there was any possibility that home prices in the United States could decline to any substantial degree.
Putting aside macro-economic conditions, Morgan Stanley is a survivor in an increasingly concentrated securities business, one of the unexpected outcomes of the credit crisis. It offers above average ratios of credit spread to default probability compared to other firms with bonds traded on April 25. The volatility of the credit spread data (based on actual trades) that we analyzed above shows that good execution is absolutely essential to make an investment in Morgan Stanley bonds "good value."
Finally, the credit-adjusted dividend yield on Morgan Stanley is 1.110% versus the traditional dividend yield calculation of 1.346%. The difference reflects the default risk of the firm and the associated risk aversion embedded in the bond prices of Morgan Stanley.
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.