## Summary

- KMP annualized default probabilities are only 0.01% at 1 year and 0.06% at 10 years, exceptionally low levels.
- KMP is under-rated by the legacy rating agencies, and uninformed investors who believe ratings have pushed down bond prices and increased credit spreads.
- The result is a unique opportunity to take advantage of those who still use 100 year old credit assessment tools to earn a top 15% reward to risk ratio.

In this note we analyze the current levels and past history of default probabilities for Kinder Morgan Energy Partners, L.P. (NYSE:KMP), one of the largest publicly traded pipeline master limited partnerships in America. We compare these default probabilities to the credit spreads on secondary market trading in Kinder Morgan Energy Partners, L.P. bonds on Tuesday, June 10, 2014. In this note, we illustrate the opportunities for investors who believe modern statistical methods out-perform legacy agency ratings, as proven by the rapidly accumulating published research. Many investors are ignorant of this statistical evidence, recent actions taken by the European Union against the rating agencies, and the 150 page litany of rating agency mistakes listed by the U.S. Senate Permanent Sub-Committee on Investigations. As a result, these uninformed investors create opportunities for better informed investors, and Kinder Morgan Energy Partners, L.P. is a classic illustration of that fact.

*Conclusion: Bond investors are dominated by those who use 100-year old credit risk assessment technology, legacy credit ratings. Kinder Morgan Energy Partners, L.P. is under-rated, even when modeling standard rating agency behavior, by 3 ratings notches. On top of this, modern default probabilities for the firm are exceptionally low. The result is bond prices that are too low and credit spreads that are too high, because "legacy investors" who believe the rating agencies still impact bond prices. The result is a company that sophisticated analysts would overwhelmingly classify as "investment grade" by the modern Dodd-Frank definition and bond prices for whom the reward to risk ratio is in the top 15% of all bonds heavily traded on June 10, 2014. There is no need to feel guilty about taking money from those investors who don't do their homework.*

## Objectives of the Analysis

Our first objective is to answer whether or not Kinder Morgan Energy Partners, L.P. would be considered "investment grade" in light of the changed definition of investment grade mandated by the Dodd-Frank Act and recently implemented by the Office of the Comptroller of the Currency. For background on Dodd-Frank and related regulatory changes, see our December 6 analysis of Citigroup Inc. (NYSE:C).

In this note, we analyze the current levels and past history of default probabilities for Kinder Morgan Energy Partners, L.P. We also measure the reward, in terms of credit spread, for taking on the default risk Kinder Morgan Energy Partners, L.P. bonds. 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. We analyze the maturities where the credit spread to default probability ratio is highest for Kinder Morgan Energy Partners, L.P.

## 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. This graph shows the current default probabilities (in green) for Kinder Morgan Energy Partners, L.P. ranging from one month to 10 years on an annualized basis. We compare them to the same default probabilities from six months earlier, graphed in yellow. Default probabilities range from 0.01% at 1 year to 0.06% at 10 years. These default probabilities are among the lowest reviewed in this series of notes.

We explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation 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. On June 10, 2014, Kinder Morgan Energy Partners, L.P. was the 37th most heavily traded issuer in the market for fixed rate corporate bonds in the United States:

Total trading in Kinder Morgan Energy Partners, L.P. fixed rate bonds was 58 trades in 13 issues with a principal amount of $48.8 million traded. We used all of this data in today's analysis.

The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Kinder Morgan Energy Partners, L.P. 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 Kinder Morgan Energy Partners, L.P. 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. This light blue curve is barely visible because the default probabilities of Kinder Morgan Energy Partners, L.P. are so low. The third curve from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on Kinder Morgan Energy Partners, L.P. 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 Kinder Morgan Energy Partners, L.P. issue recorded by TRACE. For the reader's convenience, we have added a trade volume-weighted credit spread, fitted to the trade-weighted average credit spread at each maturity. This curve is shown as black dots joined by black line segments.

The data makes it clear that there is a steady liquidity premium built into the yields of Kinder Morgan Energy Partners, L.P. above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm).

The high, low, average and fitted credit spreads at each maturity are graphed below.

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 Kinder Morgan Energy Partners, L.P. The reward from holding the bonds of Kinder Morgan Energy Partners, L.P., relative to the matched maturity default probability, ranges from 19 to 35 basis points of credit spread reward for every basis point of default risk. We compare these ratios to other bonds traded on June 10 below.

The credit spread to default probability ratios are shown in graphic form here. We have again added a traded-weighted polynomial (shown in black) relating the fitted credit spread-default probability ratio to the years to maturity on the underlying bonds.

## Relative Value Analysis

Is the reward-to-risk ratio for Kinder Morgan Energy Partners, L.P. higher than average, lower than average, or just average? Rather than guess, we simply look at the facts. The chart below shows the credit spreads for all fixed rate senior non-call debt issues which traded at least $5 million in volume on June 10, 2014 and had at least 1 year to maturity. There were 431 bond issues that met our criteria. This histogram shows the distribution of credit spreads available in the market place.

The median credit spread was 0.770% and the average credit spread was 1.042%. The next graph shows the distribution of the credit spread to default probability ratio for all trades on June 10, 2014:

The median credit spread to default probability ratio was 7.952 and the average was 13.641. How did Kinder Morgan Energy Partners, L.P. bonds rank among the 431 heavily traded bonds on June 10, 2014? First of all, the worst reward-to-risk ratio on any of the Kinder Morgan Energy Partners, L.P. bonds was 19.94, more than six full percentage points higher than the average and almost 12 percentage points higher than the median credit spread to default probability ratio. The best placed Kinder Morgan Energy Partners, L.P. bond ranked 51st, just outside the best 10 percent of all heavily-traded bonds on June 10. The other two heavily traded Kinder Morgan Energy Partners, L.P. bonds ranked 64th and 79th on the day.

## CUSIPs

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 Kinder Morgan Energy Partners, L.P. 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 Kinder Morgan Energy Partners, L.P. 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 Kinder Morgan Energy Partners, L.P. over almost 30 years. We use this data from Seeking Alpha:

The history of Kinder Morgan Energy Partners, L.P. 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 Kinder Morgan Energy Partners, L.P. at the quarterly rate of $1.38 and using the present value factors implied by Kinder Morgan Energy Partners, L.P. bond prices, we find that the long-term credit-adjusted dividend yield is 5.580%, 1.378% less than the traditional dividend yield of 6.958% (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 Kinder Morgan Energy Partners, L.P. may default, ending the dividend stream. The bond-based discount factors incorporate this fact.

The first two years of cash flow assumed and discount factors used are shown here to illustrate the methodology:

## 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 June 6, 2014 (the most recent week for which data is available), the credit default swap trading volume on Kinder Morgan Energy Partners, L.P. was as follows: 60 contracts traded during the week, representing a notional principal of $263.3 million, which ranked the company at number 118 among all reference names traded during the week.

The history of notional principal traded in the credit default swap market on Kinder Morgan Energy Partners, L.P. is shown here:

Credit default swap contract trading volume, in numbers of contracts traded, is shown here:

## Additional Analysis

On a cumulative basis, the current default probabilities, graphed in green, for Kinder Morgan Energy Partners, L.P. range from 0.01% at 1 year to 0.61% at 10 years. This is slightly lower than the default probabilities from six months earlier, graphed in yellow.

Over the last 10 years, the 1 year and 5 year default probabilities for Kinder Morgan Energy Partners, L.P. have varied as shown in the following graph. The 5 year default probabilities peaked near 0.10%, while the 1 year default probabilities hit a maximum of 0.08% during this period. The five year default probabilities have been rising fairly steadily in recent months.

The macro-economic factors driving the historical movements in the default probabilities of Kinder Morgan Energy Partners, L.P. over the period from 1990 to the present include 4 factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These factors explain 45.1% of the variation in the 1 year default probability for Kinder Morgan Energy Partners, L.P. The remaining risk, which is substantial, is the idiosyncratic risk of the firm.

Kinder Morgan Energy Partners, L.P. can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the US "energy" sector, Kinder Morgan Energy Partners, L.P. has the following percentile ranking for its default probabilities among its 477 peers at these maturities:

1 month 29th percentile

1 year 26th percentile

3 years 18th percentile

5 years 6th percentile

10 years 4th percentile

A comparison of the legacy credit rating for Kinder Morgan Energy Partners, L.P. with the best available statistical estimates mimicking rating agency behavior, provided by Kamakura Corporation, indicates that the company is * under-rated* by three ratings grades. Over the last decade, the legacy credit ratings for Kinder Morgan Energy Partners, L.P. have changed only once.

## Conclusions

We review 4 key graphs before reaching our conclusions. We compare the credit spreads and matched maturity default probabilities for Kinder Morgan Energy Partners, L.P. with two peer groups: the energy sector peer group (which consists of firms with very high credit quality) and the legacy "investment grade" peer group as defined by traditional credit ratings. We look first at the sector peer group spreads on June 10, 2014:

Kinder Morgan Energy Partners, L.P. credit spreads rank near the median of the sector peer group. Now we look at the matched maturity default probabilities for the peer group:

Kinder Morgan Energy Partners, L.P. ranks at the safest boundary of the peer group. Now we turn to the credit spreads on the investment grade peer group:

Again, Kinder Morgan Energy Partners, L.P. falls near the median of the investment grade peer group. Turning to investment grade default probabilities, we get the same result for all bonds traded on June 10, 2014: Kinder Morgan Energy Partners, L.P. falls near the safest levels in the peer group.

Our conclusions about Kinder Morgan Energy Partners, L.P. bonds are easy to state. Bond investors are dominated by those who use 100-year old credit risk assessment technology, legacy credit ratings. An increasing number of investors recognize what Harvard Prof. Gary King and Dartmouth Professor Samir Soneji noted in a recent article on social security:

"We thus use some of these new formal statistical methods…This is especially advantageous because informal forecasts may be intuitively appealing (Morera and Dawes 2006), but they suffer from humans' well-known poor abilities to judge and weight information informally (Dawes et al.1989). Indeed, a large literature covering diverse fields extending over 50 years has shown that formal statistical procedures regularly outperform informal intuition-based approaches of even the wisest and most well-trained experts (Grove 2005; Meehl 1954). (There are now even popular books on the subject, such as Ayres (2008).)"

Kinder Morgan Energy Partners, L.P. is under-rated, even when modeling standard rating agency behavior, by 3 ratings notches. On top of this, modern default probabilities for the firm are exceptionally low. The result is bond prices that are too low and credit spreads that are too high, because "legacy investors" who believe the rating agencies still impact bond prices. The result is a company that sophisticated analysts would overwhelmingly classify as "investment grade" by the modern Dodd-Frank definition and bond prices for whom the reward-to-risk ratio is in the top 15% of all bonds heavily traded on June 10, 2014. There is no need to feel guilty about taking money from those investors who don't do their homework.

## Author's Note

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.

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