AT&T Inc. Bonds: For Whom Does The Bell Toll?

We last analyzed AT&T Inc. (NYSE:T) on August 27, 2013 and the headline read "not a ringing endorsement." Then and now, the telecommunications sector around the world is experiencing enormous disruption. Monday, AT&T Inc. announced a nearly $5 billion deal by which Crown Castle International Corp. (CCI) would have exclusive leasing rights on 9,000 AT&T Inc. wireless towers. In August, we noted that bond holders of AT&T Inc. were receiving a lower than average reward-to-risk ratio compared to investment grade bonds widely available in the marketplace. In this note, we confirm that the AT&T Inc. bond reward-to-risk ratio has narrowed further, a surprising conclusion as the upheaval in telecommunications continues.

Today's study incorporates AT&T bond price data as of December 13, 2013. A total of 426 trades were reported on 26 fixed-rate non-call bond issues of AT&T with trade volume of $133.5 million.

The purpose of this note is to answer two simple questions:

1. Are the bonds of AT&T Inc. "good value" relative to other bonds available in the market place?
2. In light of the new definition of investment grade outlined at the end of this note, how would most analysts classify AT&T Inc., as investment grade or not?

Assuming the recovery rate in the event of default would be the same on all bond issues, 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/default probability ratio is highest for AT&T 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 (green line) shows the current default probabilities for AT&T Inc. ranging from one month to 10 years on an annualized basis. We assume that default probabilities for maturities over ten years are equal to 10 year default probabilities. The yellow line graphs the same default probabilities as of August 26, 2013. The default probabilities range from 0.19% at one month (up 0.03% from August) to 0.10% (up 0.02%) at 1 year and 0.57% at ten years (up 0.04%).

We explain the source and methodology for the default probabilities below.

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. We used the bond data mentioned above for 26 AT&T Inc. fixed rate non-call issues in this analysis.

The graph below shows 6 different yield curves that are relevant to a risk and return analysis of AT&T 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, interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of AT&T Inc. 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. The third line from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on AT&T Inc. bonds. The fourth line from the bottom (the green dots) displays the trade-weighted average yield reported by TRACE on the same day. The highest yield (the red dots) is obviously the maximum yield in each AT&T Inc. issue recorded by TRACE. The black dots and connecting black line represent the trade-weighted yield curve that best fits the credit spreads observed for AT&T Inc. on December 16, 2013.

The data makes it clear that there is a fairly stable liquidity premium built into the yields of AT&T Inc. above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm). The credit spreads are relatively erratic for maturities under 10 years. The credit spreads generally widen with maturity, the normal pattern for a high quality credit, with the exception of the thinly traded bonds from 20 years on out. A regular reader of this series of notes may notice that the ratio of credit spread to default probability for AT&T Inc. is narrower than normal. We document that fact in the rest of this note.

This graph, using a slightly different format, presents the same results that we reported for August 26, 2013.

The high, low and average credit spreads at each maturity are graphed below, along with the trade-weighted credit spreads consistent with a cubic polynomial on December 13. Credit spreads are generally increasing with the maturity of the bonds. We have done nothing to smooth the data reported by TRACE, 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.

The following graph, again in a slightly different format, shows the same relationship on August 26, 2013.

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 AT&T Inc. At almost all maturities under 3.5 years, the reward from holding the bonds of AT&T Inc., relative to the matched maturity default probability, is between 2.1 and 5.2 basis points of credit spread reward for every basis point of default risk. The ratio of spread to default probability decreases once the maturity of the bonds exceeds 3.5 years, falling to a spread to default ratio between 1.9 and 3.4 times. This reward to risk ratio is among the lowest of any firm analyzed in this series of bond studies. In our recent note on Citigroup, Inc., for example, the reward-to-risk ratio was as much as ten times higher than we are finding for AT&T Inc.

The results that we reported on August 26, 2013 are reported here:

The credit spread to default probability ratios are shown in graphic form here. We have again added a polynomial functional relating the credit spread to default probability ratio to the years to maturity on the underlying bonds.

The results for August 26, 2013, displayed in a different format, are given here:

The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended December 6, 2013 (the most recent week for which data is available), the trading volume for credit default swaps on AT&T Inc. was notional principal of $133,800,000 in 30 contracts, almost triple the volume reported for the week of August 16. The number of credit default swap contracts traded on AT&T Inc. in the 155 weeks ended June 28, 2013 is summarized in the following table:

AT&T Inc. ranked 170th among all reference names in weekly credit default swap trading volume during this period, which is graphed below:

On a cumulative basis, the default probabilities for AT&T Inc. range from 0.10% at 1 year (up 0.02% from August) to 5.57% at 10 years (up 0.42% from August), as shown in the following graph. Current cumulative default probabilities are shown in green and the August cumulative default probabilities are shown in yellow.

Over the last decade, the 1 year and 5 year default probabilities for AT&T Inc. have varied as shown in the following graph. The one year default probability peaked at just under 0.60% in the first half of 2009 during the worst part of the credit crisis. The 5 year default probability (annualized) peaked near 0.60% in 2005. The default probability history for AT&T Inc. is striking for two reasons. First, the peak in default probabilities is well below that of many well-known banks and industrial firms during the credit crisis. That's the good news. The bad news is that the volatility of the default probabilities has not abated as the credit crisis recedes into history. That is due to the on-going disruption in the telecommunications industry.

In a recent study by Kamakura of the 82 borrowers under the Federal Reserve's Commercial Paper Funding Facility AT&T Inc. did not need to borrow under the facility even though its competitor Verizon Communications (VZ) did so.

In contrast to the daily movements in default probabilities graphed above, the legacy credit ratings, those reported by credit rating agencies like McGraw-Hill unit Standard & Poor's and Moody's, for AT&T Inc. have changed only twice during the last decade.

The macro-economic factors driving the historical movements in the default probabilities of AT&T Inc. have 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. This assumption is complicated for AT&T Inc. and its competitors as the fundamental technology used in the telecommunications sector is undergoing a complete upheaval. With that caveat, the historical analysis shows that AT&T Inc. default risk responds to changes in the following factors among those listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review:

1. Change in real gross domestic product
2. Unemployment rate
3. 3 month U.S. Treasury bill rates
4. BBB rated corporate bond yield
5. The VIX volatility index
6. Home price index

These macro factors explain 48.4% of the variation in the default probability of AT&T Inc., a much lower than average percentage because technology factors have dominated in the determination of the firm's credit risk. The remaining 51.6% of total default risk of AT&T Inc. is idiosyncratic risk of the firm.

AT&T Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the world-wide "telecom services" sector, AT&T Inc. has the following percentile ranking for its default probabilities among its rated 81 peers at these maturities:

• 1 month 77th percentile
• 1 year 60th percentile
• 3 years 46th percentile
• 5 years 40th percentile
• 10 years 35th percentile

The percentile ranking of AT&T Inc. default probabilities at one month and one year is in the riskiest half of the telecom services peer group. The percentile ranking for AT&T Inc. at 10 years is in the 2nd safest quartile of credit risk among telecom services firms. This reflects the market prices of the firm's common stock and bonds, with investors betting that the firm is a long-term survivor in the telecommunications sector with declining risk as time goes on. That being said, the peer comparison with the risky telecom sector is favorable for AT&T Inc. mainly because the entire sector has higher default probabilities than the average industrial firm. Taking still another view, both the actual and statistically predicted AT&T Inc. credit ratings are "investment grade" by traditional credit rating standards of Moody's Investors Service and the Standard & Poor's affiliate of McGraw-Hill. The actual and statistically predicted rating are at the same level.

Conclusions

Our focus in this series of articles is not on the opinion of this analyst. Instead, the focus is on the opinion of market participants as implied by bond prices, credit spreads and default probabilities. In order to learn more about the opinions of market participants, we first plot the credit spreads of AT&T Inc. against the "technology, media and telecommunications" peer group credit spreads as of December 13:

AT&T Inc. credit spreads are slightly below the mid-point of the credit spreads for the peer group. We now turn to a comparison with the matched maturity default probabilities for the peer group on the same day:

Here, the comparison is not as favorable, with AT&T Inc. default probabilities ranging above the mid-point of the peer group.

We now compare trading in the bonds of AT&T Inc. with the traded credit spreads of bonds with a legacy "investment grade" rating from the rating agencies:

By this measure, AT&T Inc. is solidly in the middle of the pack, although it is probably above the median at the longer maturities. When we compare the default probabilities of AT&T Inc. with the matched maturity default probabilities of investment grade firms whose bonds traded on December 13, we get the following comparison:

AT&T Inc. default probabilities are strikingly above the median for the investment grade peer group.

As we said in August, AT&T Inc. is a complex credit. While the long-term peer group comparison places the firm in the 2nd quartile of credit risk, the entire telecommunications sector faces a constantly changing technological landscape and a higher than average level of default risk. This is reflected in a high degree of volatility for ATT Inc. default probabilities even though they have remained well below the 1% level at which the Kamakura Troubled Company Index labels a firm as "troubled." In spite of this concern, we believe a strong majority of analysts would define AT&T Inc. as investment grade. Note that our own views on the quality of the credit are explicitly given in the first part of this paper where we state the default probabilities for the firm. We discuss the "investment grade" analysis like a political poll, for the same reason polling is used in politics: "investment grade" involves complex perceptions of the analyst, parallel to perceptions of presidential candidates, even when everyone has identical information. The percentage ranking for "investment grade" is not 100% for any firm, just as no candidate for President of the United States has received 100% of the vote.

Even though the default probabilities of AT&T are relatively low, the ratio of the credit spreads to default probabilities for the firm are very low across the board. The attractiveness of the AT&T name and the firm's status as an icon of American industry comes with a price. All other things being equal, investors in the bonds of AT&T receive much less reward (in terms of credit spread) relative to the risk they are taking (in terms of default probabilities) compared to the bonds of other issuers. The comparison with Citigroup Inc. is just one of many examples. Given the serious disruption facing the telecommunications sector, it is surprising that bond holders are not demanding a larger risk premium from their investment in AT&T Inc. bonds.

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.

Background on Default Probabilities Used

The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. An overview of the full suite of related default probability models is available here.

General Background on Reduced Form Models

For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.

Background on the Dodd-Frank Act and the Meaning of "Investment Grade"

Section 939A of the Dodd-Frank Act states the following:

"SEC. 939A. REVIEW OF RELIANCE ON RATINGS.

(A) AGENCY REVIEW.-Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review-

(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and

(2) any references to or requirements in such regulations regarding credit ratings.

(B) MODIFICATIONS REQUIRED.-Each such agency shall modify any such regulations identified by the review conducted under subsection to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.

(C) REPORT.-Upon conclusion of the review required under subsection , each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection .

The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:

"In this rulemaking, the OCC has amended the regulatory definition of 'investment grade' in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is 'investment grade,' banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution's risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised 'investment grade' standard."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.