General Electric Company (NYSE:GE) is one of the most complex conglomerates in the world. While GE is normally thought of as an industrial company, its financial services subsidiary General Electric Capital Corporation is so large that some third party data vendors list both entities as financial services firms. This note uses the default probabilities and bond credit spreads of General Electric Capital Corporation, the financial services subsidiary of General Electric Company, to measure the reward-to-risk ratio on the company's bonds. This study is complicated by the fact that General Electric Company does not give an explicit guaranty on the bonds of General Electric Capital Corporation, a rare strategy among corporate bond issuers. Instead, it commits via an income maintenance agreement that the ratio of earnings to fixed charges at General Electric Capital Corporation will not fall below 1.1. We first analyzed the risk of General Electric Company bonds on July 11, 2013. Today's study incorporates General Electric Capital Corporation bond price data as of September 3, 2013. A total of 1,227 trades were reported on 181 fixed-rate non-call bond issues of General Electric Capital Corporation with trade volume of $461.4 million. After eliminating issues with flawed data, we analyze the remaining 1,174 trades on 162 bonds in this note. There was also trading in 4 bond issues of General Electric Company itself on September 3, but we leave the comparison between the bonds of the two legal entities for another day.
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 firm to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which requires that credit rating references be eliminated. The new rules delete references to legacy credit ratings and replace them with default probabilities as explained here.
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 General Electric Capital Corporation, recognizing there is a lack of an explicit guaranty by General Electric 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. Kamakura Risk Information Services has an actively used non-public firm default probability model for non-public firms like General Electric Capital Corporation. In this note, however, we focus instead on the default probabilities of the parent company General Electric Company in light of the income maintenance agreement cited above. The graph below shows the current default probabilities for General Electric Company ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.18% at one month to 0.07% at 1 year and 0.38% at ten years. These default probabilities reflect a twist in the term structure of default probabilities since July 11. The one month default probability is up 0.04%, the one year default probability is up 0.01%, and the 10 year default probability is down 0.03% since July 11, 2013.
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 162 General Electric Capital Corporation fixed rate non-call issues in this analysis.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of General Electric Capital Corporation bonds. These curves reflect the noise in the TRACE data, as some of the trades are small odd-lot trades. The noise in GECC bond data is greater than it is for other corporations analyzed in this series of notes. One of the main reasons for the noise is that some of General Electric Capital Corporation bonds were issued with a guaranty by the Federal Deposit Insurance Corporation during the credit crisis. 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 General Electric Capital Corporation. 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 (in orange) graphs the lowest yield reported by TRACE on that day on General Electric Capital Corporation bonds. The fourth line from the bottom (in green) displays the average yield reported by TRACE on the same day. The highest yield is obviously the maximum yield in each General Electric Capital Corporation issue recorded by TRACE.
The liquidity premium built into the yields of General Electric Capital Corporation above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm) is very erratic, particularly on the short end of the curve. The credit spreads are particularly erratic for maturities under 6 years. The credit spreads generally widen with maturity, the normal pattern for a high quality credit, although there are many outliers around this trend.
The high, low and average credit spreads at each maturity are graphed below. 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 cubic polynomial that explains the average spread as a function of years to maturity. This polynomial explains 49.66% of the variation in the average credit spread over the maturity term structure, a much more erratic pattern than for the bonds of AT&T Inc. (NYSE:T). For AT&T Inc., the polynomial explained 93% of the variation in credit spreads:
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 General Electric Capital Corporation using the very important and optimistic assumption that the default probabilities of GECC are equal to those of General Electric Company. At short maturities, the credit spread to default probability ratio varies wildly, from about 1.5 times to more than 12 times. The ratio of spread to default probability decreases once the maturity of the bonds exceeds 5 years, falling to a spread to default ratio between 3 and 5 times. This reward to risk ratio is among the lowest of any firm analyzed in this series of bond studies, even though we are using the optimistic assumption that General Electric Capital Corporation is no more risky than General Electric Corporation. By comparison, in our recent note on Citigroup, Inc., the reward-to-risk ratio was as much as six times higher than we are finding for General Electric Capital Corporation.
The credit spread to default probability ratios are shown in graphic form here. We have again added a cubic polynomial relating the credit spread to default probability ratio to the years to maturity on the underlying bonds. The smoothed line explains about 30% of the variation in the reward to risk ratio, 15% less than for AT&T Inc.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended August 30, 2013 (the most recent week for which data is available), the credit default swap trading volume on General Electric Capital Corporation was 10 trades with $33.1 million of notional principal, a small fraction of the daily bond trading volume on September 3. The number of credit default swap contracts traded on General Electric Capital Corporation in the 155 weeks ended June 28, 2013 is summarized in the following table:
General Electric Capital Corporation ranked 16th 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 General Electric Company, the parent, range from 0.07% at 1 year to 3.73% at 10 years, as shown in the following graph.
Over the last decade, the 1 year and 5 year default probabilities for General Electric Company, the parent, have varied as shown in the following graph. The one year default probability peaked at just under 4.00% in the first half of 2009 during the worst part of the credit crisis. As we noted in our July 11, 2013 report, the General Electric family of companies was an active borrower under the Federal Reserve's Commercial Paper Funding Facility during the credit crisis. General Electric Capital Corporation was also an active issuer of debt guaranteed by the FDIC during the credit crisis as noted above.
The details of General Electric borrowings from the Federal Reserve can be found in a recent study by Kamakura Corporation of the 82 borrowers under the Federal Reserve's Commercial Paper Funding Facility.
In contrast to the daily movements in default probabilities graphed above, the legacy credit ratings [those reported by credit rating agencies like McGraw-Hill (NYSE:MHFI) unit Standard & Poor's and Moody's (NYSE:MCO)] for General Electric Company have changed only once during the decade.
The macro-economic factors driving the historical movements in the default probabilities of General Electric Company, the parent, 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. With that caveat, the historical analysis shows that General Electric Company default risk responds to changes in the following factors among those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
- Change in nominal gross domestic product
- Unemployment rate
- 3 month U.S. Treasury bill rates
- BBB rated corporate bond yield
- 30 year fixed rate mortgage yields
- The VIX volatility index
- Home price index
- Commercial real estate prices
- 3 international macro factors
These macro factors explain 91.6% of the variation in the default probability of General Electric Company, a higher than average.
General Electric Company, the parent, 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 "capital goods" sector, General Electric Company has the following percentile ranking for its default probabilities among its 393 peers at these maturities:
1 month 79th percentile
1 year 66th percentile
3 years 50th percentile
5 years 38th percentile
10 years 35th percentile
The percentile ranking of General Electric Company default probabilities at one month through three years is in the riskiest half of the capital goods peer group. The percentile ranking for General Electric Company at 5 and 10 years is in the 2nd safest quartile of credit risk among capital goods firms. Taking still another view, both the actual and statistically predicted General Electric Company 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 bad news is that the statistically predicted rating is six notches below the legacy rating, making General Electric Company one of the most over-rated companies in the United States.
General Electric Company is a complex credit. Its financial services subsidiary General Electric Capital Corporation is more complex still. The viability of a financial services firm that relies completely on wholesale markets for funding is questionable. During the last twenty years, many famous names have abandoned that business model either voluntarily or involuntarily, through merger or failure: Industrial Bank of Japan, Long-term Credit Bank of Japan, Nippon Credit Bank, Continental Illinois, First Chicago, Bankers Trust, and JPMorgan (NYSE:JPM). Given the riskiness of the wholesale funding strategy, it is even more remarkable that the parent company General Electric Company has determined that a luke-warm income maintenance agreement with General Electric Capital Corporation is the strongest credit support it is willing to give. While there is no doubt that a strong majority of analysts would rate the bonds of General Electric Capital Corporation as investment grade, the reward for bearing the risk of default or a spin-off from General Electric Company is below average compared to other firms featured in this series of notes. Investors can earn a much higher spread to default probability ratio on the bonds of other issuers.
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.
Additional disclosure: Kamakura Corporation has business relationships with a number of companies mentioned in this article.