Frontier: High-Yield Bonds Vs. Stock Vs. Options

To the chagrin of yield-chasers, Frontier Communications (FTR) finally cut its big dividend. Specifically, the dividend was reduced by 62% last week (it now sits at 13.2%), and the stock is now down 64% this year. For your consideration, this article reviews the potential risks and rewards of investing in Frontier's high-yield bonds (+10% YTM), big-dividend stock, and leveraged options.

Overview

Frontier provides phone, Internet and data services to urban, suburban and rural communities in 29 states. The company has been struggling with customer attrition, challenging integration issues (they recently acquired assets from Verizon in California, Texas and Florida), and a significant amount of debt. Despite the significant price decline, the recent dividend cut is a strong signal from managements that they believe a more stable Frontier is around the corner.

The High-Yield Bonds

As the following chart shows, AT&T has various magnitudes of high-yield debt outstanding (some of which offers double digit yield) that will mature in the coming years.

And as the discounts and premiums to par in the following table indicate, the market has a high degree of confidence in the company’s near-term bonds, but not so much the longer-term bonds.

For example, the outstanding 2018 – 2020 bonds all trade at a premium to par (and offer reasonable yields to maturity), indicating the bond market believes the chances of default are less likely than the longer dated bonds. On the other hand, the outstanding bonds that mature in 2021 and beyond trade at discounts to par (and offer significantly higher yields to maturity) an indication that the bond market has far less confidence in Frontier beyond 2020. Said differently, Frontier appears to have the financial wherewithal to stay afloat for a couple more years, but beyond that timeframe things are very uncertain.

Referring back to our earlier graph of debt maturities and magnitudes, Frontier should have no problem meeting its debt obligations in 2017. It has $341 million of cash and short-term investments on its balance sheet, and only $325 million of 2017 debt maturities (much of which has already been paid off).

Next, we agree with the market’s assessment that Frontier should be able to manage its 2018 – 2020 debts (remember, these trade above par, an indication of market confidence relative to the later dated bonds that trade at a discount). Specifically, despite Frontier’s struggles, it has continued to generate hundreds of millions of dollars of positive free cash flow year after year (see chart below), and this will help pay the 2018 – 2020 debt maturities. Not to mention, the recent dividend cut frees up significantly more cash (hundreds of millions per year) to help support the debt payments.

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Disclosure: None.

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