- Kraft's default probabilities are down significantly in the last 6 months and rank in the safest 13% of the food, beverage and tobacco peer group.
- Kraft's legacy rating is too low by two notches when modern statistical methods are used to mimic legacy ratings.
- In part because of that, the bonds offer solid value. Only 36 of 206 bonds heavily traded on June 30 offered a better spread to default probability ratio.
Kraft Foods Group Inc. (NASDAQ:KRFT) is one of the largest consumer packaged goods companies in North America, with 22,500 employees across the U.S. and Canada and $18 billion in annual sales. The company was formed in a demerger from former parent Kraft Foods Inc. (since renamed) in 2012. In this note, we turn to the U.S. dollar bonds issued by Kraft Foods Group Inc. and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on June 30, 2014. A total of 53 trades were reported on 8 fixed-rate bond issues of Kraft Foods Group Inc. with June 30 trading volume of $52.8 million. We use this information for three purposes: to evaluate the risk and return on the firm's bonds, to evaluate the firm's credit risk-adjusted dividend yield, and to reach a conclusion on investment grade status by the modern "Dodd-Frank" definition.
Conclusion: We believe that a majority of sophisticated analysts would rate Kraft Foods Group Inc. a solid "investment grade" company by the modern Dodd-Frank definition. The statistical prediction for the legacy rating shows the firm to be under-rated by 2 notches. The default probabilities of the firm are down substantially over the last 6 months and rank in the best 13% of the food, beverages and tobacco peer group at all maturities but 1 month, where the default probability is 0.01%. The fact that credit default swaps have not traded on Kraft Foods Group Inc. since its 2012 demerger confirm that there is not a wide divergence of opinion on the credit risk of the firm. The bonds offer solid value by our normal criterion for "best," the ratio of the credit spread to default probability. Only 36 of 206 heavily traded bonds offered better value than the best bond traded for Kraft Foods Group Inc.
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 Kraft Foods Group Inc. 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 (NYSE:C) 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 to default probability ratio is highest for Kraft Foods Group 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 shows the current default probabilities for Kraft Foods Group Inc. (green line) ranging from one month to 10 years on an annualized basis. We plot the current default probabilities versus the default probabilities for Kraft Foods Group Inc. six months earlier on December 30, 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 Kraft Foods Group Inc. default probabilities range from 0.01% at one month to 0.00% at 1 year (the default probability is positive but rounds to zero at the second decimal place) and 0.12% at ten years.
We also 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. The total of all fixed rate debt issued by Kraft Foods Group Inc. and traded on June 30 is reported here. Kraft Foods Group Inc. was the 11th most actively traded issuer.
There were no callable bonds or non-senior bonds among the total for Kraft Foods Group Inc., so we used all of the data above in today's analysis.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Kraft Foods Group 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 (NYSEARCA:TLT) (NYSEARCA:TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of Kraft Foods Group 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 line graphs the lowest yield reported by TRACE on that day on Kraft Foods Group Inc. 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 Kraft Foods Group Inc. bond issue recorded by TRACE. The black dots and connecting black line represent the yields consistent with a trade-weighted fitted credit spread we discuss below.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Kraft Foods Group Inc. This increasing liquidity premium 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 Kraft Foods Group Inc. 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 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. For Kraft Foods Group Inc., the credit spread to default probability ratio ranges from 8 to more than 80 times. The ratios of spread to default probability for all traded bond issues are shown here:
The credit spread to default probability ratios are shown in graphic form below for Kraft Foods Group Inc.
Relative Value Analysis
How does the credit spread to default probability ratio for Kraft Foods Group Inc. 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 Kraft Foods Group Inc. with all 206 fixed-rate non-call senior bond issues with a daily trading volume of at least $5 million on June 30 and a maturity of 1 year or more. The first graph shows a histogram of the credit spreads that prevailed on these issues on June 30, 2014:
The median credit spread was 0.857% and the average was 1.142%. 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 9.949 and the average ratio is 17.504.
The ratio of credit spread to default probability is shown in this chart for all of the Kraft Foods Group Inc. bonds with at least $5 million in trading volume and maturities over 1 year. The two heavily traded Kraft Foods Group Inc. bonds rank 37th and 98th, above the 103rd bond, the median of all heavily traded bonds when ranked by our value criterion. Looking at maturities of 20 years or more, the Kraft Foods Group Inc. 5% bonds due June 4, 2042 rank 15th of the 45 bonds in that heavily traded bond peer group.
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 Kraft Foods Group 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 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 Kraft Foods Group 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 Kraft Foods Group Inc. over almost 30 years. We use this data from Seeking Alpha:
The history of Kraft Foods Group Inc. 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 Kraft Foods Group Inc. at the quarterly rate of $0.525 and using the present value factors implied by Kraft Foods Group Inc. bond prices, we find that the long-term credit-adjusted dividend yield is 3.020%, 0.467% less than the traditional dividend yield of 3.487% (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 Kraft Foods Group Inc. 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.
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 20, 2014 (the most recent week for which data is available), the credit default swap trading volume on Kraft Foods Group Inc. was zero. Since the 2012 demerger from former parent Kraft Foods Inc. (which has since been renamed), there have been no credit default swap trades in Kraft Foods Group Inc.
On a cumulative basis, the current default probabilities (in green) for Kraft Foods Group Inc. range from 0.00% at 1 year (after rounding) to 1.24% at 10 years. The December 24, 2013 cumulative default probabilities are graphed in orange.
Since the 2012 demerger from Kraft Foods Inc., the 1-year and 5-year annualized default probabilities for Kraft Foods Group Inc. have varied modestly. The 1-year default probability (in blue) peaked at slightly over 0.02% in early 2014. The 5-year default probability (in yellow) peaked at almost 0.12% on an annualized basis at the same time.
Kraft Foods Group 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 US "food, beverage and tobacco" sector, Kraft Foods Group Inc. has the following percentile ranking for its default probabilities among its 124 peers at these maturities:
1 month 28th percentile
1 year 0 percentile, tied with many others
3 years 9th percentile
5 years 13th percentile
10 years 10th percentile
Over all but the shortest time horizon, Kraft Foods Group Inc. ranks in the safest 13% of its peer group from a credit risk perspective.
Taking still another view, the actual and statistically predicted Kraft Foods Group Inc. credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is 2 notches above the legacy rating from firms like the Standard & Poor's affiliate of McGraw-Hill (NYSE:MHFI) and Moody's Investors Service (NYSE:MCO). The legacy ratings of the company have not changed from November 2012 to the present.
We postpone our conclusions briefly to view some more facts. The "consumer products" peer credit spreads on June 30 are shown here in light blue, with Kraft Foods Group Inc. credit spreads plotted in dark blue. Kraft Foods Group Inc. credit spreads are near the median. We remind readers that the traded bond peer group generally has higher average quality than the full peer group universe.
The matched maturity default probabilities for the "consumer products" peer group with bonds traded on June 30 are shown in this graph:
Kraft Foods Group Inc. is again in the middle of the peer group by this measure. Investment grade credit spreads on all bonds traded on June 30 are shown here in light blue with Kraft Foods Group Inc. credit spreads plotted in dark blue:
Kraft Foods Group Inc. falls below the middle of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus Kraft Foods Group Inc.:
Kraft Foods Group Inc. is again near the safest part of the investment grade peer group.
We believe that a majority of sophisticated analysts would rate Kraft Foods Group Inc. a solid "investment grade" company by the modern Dodd-Frank definition. The statistical prediction for the legacy rating shows the firm to be under-rated by 2 notches. The default probabilities of the firm are down substantially over the last 6 months and rank in the best 13% of the food, beverages and tobacco peer group at all maturities but 1 month, where the default probability is 0.01%. The fact that credit default swaps have not traded on Kraft Goods Group Inc. since its 2012 demerger confirm that there is not a wide divergence of opinion on the credit risk of the firm. The bonds offer solid value by our normal criterion for "best," the ratio of the credit spread to default probability. Only 36 of 206 heavily traded bonds offered better value than the best bond traded for Kraft Foods Group Inc. on June 30.
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.