The Walt Disney Company Bonds: Very Low Default Risk At A 'No Brand' Price

Jul.15.14 | About: The Walt (DIS)

Summary

The Walt Disney Company ranks 17th on the Forbes list of most valuable brands, and its default risk is in the best 3% of technology, media and telecommunications peers.

Most "brand name" company bonds we have reviewed to date do not offer "good value" as measured by the ratio of credit spread to default probability.

The Walt Disney Company is an exception, with its bonds trading near the "best value" median on July 11, 2014.

The Walt Disney Company (NYSE:DIS) ranks 17th on the Forbes ranking of the world's most valuable brands. In this note, we turn to the U.S. dollar bonds issued by the Walt Disney Company and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on July 11 and 14, 2014. A total of 65 trades were reported on 8 fixed-rate bond issues of the Walt Disney Company with trading volume of $28.9 million on July 11. The Walt Disney Company was the 16th most actively traded corporate bond issuer on July 11. On July 14, there were 45 trades in 10 bond issues for $5.8 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 strong majority of sophisticated analysts would rate the Walt Disney Company a solid "investment grade" company by the modern Dodd-Frank definition. Regular readers know that the exceptionally low default risk of the Walt Disney Company is rare, much appreciated, and insufficient reason to buy the bonds. We need to ask one more question in that regard: are the bonds "good value" relative to their default risk? We have often found that the answer is "no" for iconic brand names. With respect to the Walt Disney Company, however, the good news is that the bonds offer value near the median of all heavily traded bonds on July 11.

The Analysis

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 the Walt Disney Company 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 to default probability ratio is highest for the Walt Disney Company.

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 the Walt Disney Company (green line) ranging from one month to 10 years on an annualized basis. We plot the current default probabilities versus the default probabilities for the Walt Disney Company six months earlier on January 14, 2014 (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 default probabilities for the Walt Disney Company range from 0.00% at one month (the actual default probabilities are positive but round to zero at 2 decimal places) to 0.00% at 1 year (same comment) and 0.15% at ten years. The default probabilities have dropped substantially since January.

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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 the Walt Disney Company and traded on July 14 is reported here.

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There were no callable bonds or non-senior bonds among the total for the Walt Disney Company, 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 the Walt Disney Company 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 Walt Disney Company. 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 the Walt Disney Company 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 of the Walt Disney Company bond issues 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 the Walt Disney Company. This increasing liquidity premium is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.

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The high, low, average, and fitted credit spreads at each maturity are graphed below for the Walt Disney Company. 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.

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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 the Walt Disney Company, the credit spread to default probability ratio ranges from 3.5 to more than 30 times. The ratios of spread to default probability for all traded bond issues are shown here:

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The credit spread to default probability ratios are shown in graphic form below for the Walt Disney Company.

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Relative Value Analysis

How does the credit spread to default probability ratio for the Walt Disney Company 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 the Walt Disney Company with all fixed-rate non-call senior bond issues with a daily trading volume of at least $5 million and a maturity of 1 year or more. Because trading in the bonds of the Walt Disney Company was light on July 14, we use the heavier trading from July 11 in this section of our analysis. The first graph shows a histogram of the credit spreads that prevailed on these issues on July 11, 2014:

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There were 103 issues that met our criteria on July 11. The median credit spread was 0.841% and the average was 1.173%. 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 9.192 and the average ratio is 14.418.

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The ratio of credit spread to default probability is shown in this chart for all of the Walt Disney Company bonds with at least $5 million in trading volume and maturities over 1 year. The two heavily traded bonds of the Walt Disney Company bonds rank 51st and 66th, near the 52nd bond, the median of all heavily traded bonds when ranked by our value criterion.

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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 search 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 the Walt Disney Company 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:

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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 the Walt Disney Company, which pays its dividends once per year. 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 the Walt Disney Company over almost 30 years. We leave this exercise for another post, but interested readers should feel free to contact the author for more information.

Credit Default Swap Analysis

The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. We summarize the trading activity for the Walt Disney Company in the following table, which reports on credit default swap trading for the 207 weeks ended July 4, 2014. The Walt Disney Company ranked 347th in trading volume over this 4-year period.

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The notional principal of credit default swaps traded on the Walt Disney Company over this period is summarized in this graph:

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The number of credit default swap contracts traded on the Walt Disney Company is shown here:

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Additional Analysis

On a cumulative basis, the current default probabilities (in green) for the Walt Disney Company range from 0.00% at 1 year (after rounding) to 1.51% at 10 years. The January 14, 2014 cumulative default probabilities are graphed in orange.

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The 1-year default probability (in blue) peaked at slightly over 0.70% in 2008-2009. The 5-year default probability (in yellow) peaked at near 0.40% on an annualized basis at the same time.

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The firm's default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. For an explanation, see the references in each Instablog posted by Kamakura Corporation. 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 the Walt Disney Company 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 the Walt Disney Company default risk responds to changes in 7 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 79.3% of the variation in the default probability of the Walt Disney Company. The remaining variation is the estimated idiosyncratic credit risk of the firm.

The Walt Disney Company 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 "media" sector, the Walt Disney Company has the following percentile ranking for its default probabilities among its 121 peers at these maturities:

1 month 0th percentile, tied with many others

1 year 0th percentile, fourth lowest

3 years 0th percentile, lowest

5 years 3rd percentile, fifth lowest

10 years 2nd percentile, fourth lowest

The Walt Disney Company ranks in the safest 3% of its peer group from a credit risk perspective. This is among the best default risk performance record in this series of notes.

Taking still another view, the actual and statistically predicted Walt Disney Company credit ratings both show a rating 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 (MHFI) and Moody's Investors Service (NYSE:MCO). The legacy ratings of the company have changed twice in the last decade.

Conclusions

We postpone our conclusions briefly to view some more facts. The "technology, media and telecommunications" peer credit spreads on July 14 are shown here in light blue, with the Walt Disney Company credit spreads plotted in dark blue. The Walt Disney Company credit spreads are among the very lowest in the peer group. We remind readers that the traded bond peer group generally has higher average quality than the full peer group universe.

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The matched maturity default probabilities for the "technology, media and telecommunications" peer group with bonds traded on July 14 are shown in this graph:

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The Walt Disney Company is again at the lowest levels of the peer group by this measure. Investment grade credit spreads on all bonds traded on July 14 are shown here in light blue with the Walt Disney Company credit spreads plotted in dark blue:

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The Walt Disney Company credit spreads are among the lowest of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus the Walt Disney Company:

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The Walt Disney Company is again near the safest part of the investment grade peer group.

We believe that a strong majority of sophisticated analysts would rate the Walt Disney Company a solid "investment grade" company by the modern Dodd-Frank definition. Regular readers know that the exceptionally low default risk of the Walt Disney Company is rare, much appreciated, and insufficient reason to buy the bonds. We need to ask one more question in that regard: are the bonds "good value" relative to their default risk? We have often found that the answer is "no" for iconic brand names. With respect to the Walt Disney Company, however, the good news is that the bonds offer value near the median of all heavily traded bonds on July 11.

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.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.