American International Group Inc. (NYSE:AIG) was one of the largest beneficiaries of U.S. government support during the credit crisis, but the U.S. government's shareholder status ended in December 2012. In this note, we turn to the U.S. dollar bonds issued by American International Group Inc. and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on July 28, 2014. A total of 38 trades were reported on 9 fixed-rate bond issues of American International Group Inc. with trading volume of $40.4 million on July 28. American International Group Inc. was the 17th most actively traded corporate bond issuer on July 28. 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 American International Group Inc. a solid "investment grade" company by the modern Dodd-Frank definition. The recovery from its "near-death experience" to a credit quality that tops IBM is a very impressive accomplishment. Just as impressive is the fact that American International Group Inc. bonds offer a reward to risk ratio, as measured by the ratio of credit spread to matched-maturity default probability, which is double the median level for all heavily traded bonds on July 28.
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 American International 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 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 American International 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 American International 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 American International Group Inc. six months earlier on January 28, 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 American International Group Inc. range from 0.02% at one month to 0.01% at 1 year and 0.07% at ten years. The default probabilities have dropped substantially since January. Note that the ten-year default probability is lower than the 0.09% ten-year default probability we reported for International Business Machines Corp. (NYSE:IBM) in a recent note.
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 American International Group Inc. and traded on July 28 is reported here.
There were no callable bonds or non-senior bonds among the total for American International 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 American International 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 American International 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 dots graph the lowest yield reported by TRACE on that day on American International Group Inc. bonds. The green dots display the value-weighted average yield reported by TRACE on the same day. The red dots represent the maximum yield in each of American International Group Inc. 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 American International 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 American International 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 American International Group Inc., the credit spread to default probability ratio ranges from 17.4 to more than 38 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 American International Group Inc.
Relative Value Analysis
How does the credit spread to default probability ratio for American International 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 American International Group Inc. 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. The first graph shows a histogram of the credit spreads that prevailed on these issues on July 28, 2014:
There were 181 issues that met our criteria on July 28. The median credit spread was 0.795% and the average was 1.133%. 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 10.186 and the average ratio is 20.808.
The ratio of credit spread to default probability is shown in this chart for all of American International Group Inc. bonds with at least $5 million in trading volume and maturities over 1 year. The two heavily traded bonds of American International Group Inc. bonds rank 46th and 49th, well above the 91st bond, the median of all heavily traded bonds when ranked by our value criterion. The credit spread to default probability ratio on both bonds is more than double the median 10.186 ratio noted above.
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is illegal under 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 American International 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 American International 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 American International Group Inc. over almost 30 years. We used this information in our analysis:
At the current quarterly dividend rate of $0.125, American International Group Inc.'s traditional dividend yield is 0.935%. Over 30 years, after adjusting for the credit risk in the dividend flow, the risk-free equivalent dividend yield is 0.813%. This is the credit-adjusted dividend yield for American International Group Inc. It represents the yield on a credit-risk free firm with the same present value as the dividends from American International Group Inc. when they are discounted at the zero coupon yields implied by today's bond prices. We show the first 24 months of this 30 year calculation here:
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 American International Group Inc. in the following table, which reports on credit default swap trading for the week ended July 18, 2014. American International Group Inc. ranked 30th in trading volume during this period.
The notional principal of credit default swaps traded on American International Group Inc. over the period from July 2010 to the present is summarized in this graph:
The number of credit default swap contracts traded on American International Group Inc. during the same time period is shown here:
On a cumulative basis, the current default probabilities (in green) for American International Group Inc. range from 0.01% at 1 year to 0.73% at 10 years. The January 28, 2014 cumulative default probabilities are graphed in orange.
Next, we show the history of default probabilities for American International Group Inc. in its rehabilitation period after the credit crisis. The one-year default probability, shown in blue, hit 1.20% in late 2011. The five-year annualized default probability, shown in orange, peaked near 0.40% at the same time.
This experience contrasts sharply with the term structure of default on September 16, 2008, when the U.S. government cash injections began in large size. At the time, the ten-year cumulative default risk was 73.37%, and this default probability level was lower than the true figure because the bail-out in process kept the stock price higher than its "stand-alone, business as usual" level.
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 American International Group Inc. 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 American International Group Inc. default risk responds to changes in 3 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 72.2% of the variation in the default probability of American International Group Inc. The remaining variation is the estimated idiosyncratic credit risk of the firm.
American International 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 "insurance" sector, American International Group Inc. has the following percentile ranking for its default probabilities among its 121 peers at these maturities:
1 month 62nd percentile
1 year 36th percentile
3 years 31st percentile
5 years 18th percentile
10 years 16th percentile
American International Group Inc. ranks in the safest 20% of its peer group from a credit risk perspective at maturities of 5 years and over. This is an impressive turnaround.
Taking still another view, the actual and statistically predicted American International Group Inc. credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is identical to 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 four times in the last decade.
We postpone our conclusions briefly to view some more facts. The "insurance" sector peer credit spreads on July 28 are shown here in light blue, with American International Group Inc. credit spreads plotted in dark blue. American International Group Inc. credit spreads are near the median of the peer group. 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 "insurance" peer group with bonds traded on July 28 are shown in this graph:
American International Group Inc. is again near the median of the peer group by this measure. Investment grade credit spreads on all bonds traded on July 28 are shown here in light blue with American International Group Inc. credit spreads plotted in dark blue:
American International Group Inc. credit spreads are again near the median of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus American International Group Inc.:
American International Group Inc. is near the safest part of the investment grade peer group.
We believe that a strong majority of sophisticated analysts would rate American International Group Inc. a solid "investment grade" company by the modern Dodd-Frank definition. The recovery from its "near-death experience" to a credit quality that tops IBM is a very impressive accomplishment. Just as impressive is the fact that American International Group Inc. bonds offer a reward to risk ratio, as measured by the ratio of credit spread to matched-maturity default probability, which is double the median level for all heavily traded bonds on July 28.
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.