As Seeking Alpha's growth expands its stable of contributors, the challenge for a given author to present their readership with unique and differentiated content will heighten. When I reflect on what distinctive perspective I can provide, I believe that value for the reader can be created by tying my knowledge base from my role as an institutional portfolio manager to Seeking Alpha's retail-tilted readership. This article discusses an institutional topic, credit default swap spreads, in a way that hopefully connects with individual investors. Credit default swaps are insurance-like agreements where the seller of protection agrees to compensate the buyer of protection in the event of a default by the underlying company. In exchange, the seller of protection is paid quarterly premiums over the life of the contract. The standard contract is five years, and the spreads below will reference this tenor, but maturities are often quoted from 3 months to 10 years. The higher the premium paid, then the greater the likelihood of default by the underlying company as priced by an institutional marketplace.
As the most utilized domestic equity benchmark, many of my articles dissect the constituents of the S&P 500. From Bloomberg, I can pull in credit default swap spreads on 288 of the 500 constituents. Not all constituents have readily priced markets in their credit default swaps because some may not have unsecured debt outstanding [e.g. Amazon (AMZN) or Apple (AAPL)] while others may not be of institutional size that would warrant an active market in credit default swaps on their outstanding debt.
Below is a list of the 25 constituents of the S&P 500 with the largest credit default swap spreads. Institutional investors will pay the highest premium to protect against a default on these companies' debt obligations. (CDS Spread premiums are annualized figures.)
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Of note, several of the highest dividend payers in the S&P 500 are included in the list of securities with the highest default risk. The top four dividend payers are all included: Frontier Communications (FTR), Windstream (WIN), Pitney Bowes (PBI), and R.R. Donnelley (RRD). Investors who seek dividends as an alternative or supplement to fixed income and rely on the stable income streams should understand that these companies are deemed by a somewhat opaque institutional market as the most likely to default on their debt obligations. Since debt is senior in the capital structure, this typically means that the equity is completely wiped out. The steady dividend streams belie highly levered capital structures, and secularly declining business models. With an implied recovery on the face value of debt of 40% (long-run historical recovery), the credit default swap spread on top dividend payer Frontier Communications implies a 43.4% probability of default over the next five years.
For comparison, below is a list of the 25 constituents of the S&P 500 with the lowest credit default swap spreads. These companies are typically the titans of their industries and are the most creditworthy constituents in the S&P 500.
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Pitney Bowes, 21st highest CDS spread, has increased its dividend for the last thirty years. Investors can look at this track record, and make the faulty assumption that this mail stream solutions company will continue its steady return stream well into the future. The credit default swap market presaged Monday's multi-notch downgrade by Moody's, and is pricing in even higher levels of stress than the rating agencies over the intermediate term. I present this CDS data as another tool for Seeking Alpha readers to evaluate a business profile.
Of course, rising credit default swap spreads are not always bad for equity holders. Consider a company that unexpectedly issued debt and used the proceeds to repurchase shares that were producing a higher earnings yield than the financing cost. In this case, existing bondholders (and those "long" through CDS) would be hurt as more debt is required to be serviced with the same cash flows, but equity holders could benefit from spreading earnings over a smaller number of shares.
I hope this article helps readers better understand credit default swap spreads, which are increasingly used in financial journalism. Distinguishing between credit impaired and credit worthy companies can help dividend investors build more stable income streams. Future articles will show changes in credit default swap spreads, and attempt to relate this market to implications for your stock holdings.
Disclosure: I am long SPY.
