In this note, we turn to the bonds of another iconic American industrial company, Intel Corporation (NASDAQ:INTC). We seek to bring a bond market perspective to the outlook for Intel Corporation as a complement to analysis based on a common stock holder's perspective. Today's note incorporates Intel Corporation bond price data as of October 2, 2013, including data on the large bond issues launched in September and December of 2012. A total of 132 trades were reported on 9 fixed-rate non-call bond issues of Intel Corporation with trading volume of $40.3 million. After eliminating data errors, we used data on 7 bond issues with 114 trades worth $24.8 million in this note.
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 Intel Corporation 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 Intel Corporation.
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 Intel Corporation ranging from one month to 10 years on an annualized basis. For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The default probabilities range from 0.14% at one month to 0.06% at 1 year and 0.33% at ten years.
We also 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 7 bond issues mentioned above in this analysis.
The graph below shows 5 different yield "curves" that are relevant to a risk and return analysis of Intel Corporation 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 Intel Corporation. The 1 month U.S. Treasury rate is up about 0.05% from last week due to the impasse over the U.S. government debt ceiling that is on-going as this note was written. 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 line graphs the lowest yield reported by TRACE on that day on Intel Corporation bonds. The green line displays the average yield reported by TRACE on the same day. The red line is the maximum yield in each Intel Corporation issue recorded by TRACE.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Intel Corporation. This is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for Intel Corporation. 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. The polynomial explains 94.3% of the variation in credit spreads over the maturity spectrum.
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 Intel Corporation, the credit spread to default probability ratio ranges from 3.58 times to 4.24 times, a narrow range for the reward to risk ratio. 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 Intel Corporation. The fitted polynomial explains 34.38% of the variation in the reward to risk ratios by maturity.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended September 27, 2013 (the most recent week for which data is available), the credit default swap trading volume on Intel Corporation was zero. The number of credit default swap contracts traded on Intel Corporation in the 155 weeks ended June 28, 2013 is also zero. The lack of trading volume doesn't necessarily indicate that a reference name is a high quality credit. More precisely, the lack of volume indicates that there is so little difference of opinion among market participants about the quality of the credit that no trades take place.
On a cumulative basis, the default probabilities for Intel Corporation range from 0.06% at 1 year to 3.21% at 10 years, a level of long term risk about 9 times higher than the level for Berkshire Hathaway Inc. (NYSE:BRK.A)(NYSE:BRK.B) that we analyzed earlier this week.
Over the last decade, the 1 year and 5 year annualized default probabilities for Intel Corporation have remained at a low level that many of the largest financial institutions in the world would envy. The 1 year default probability peaked at slightly over 0.35% in 2009. The 5 year default probability peaked at slightly under 0.25% earlier this year.
As explained at the end of the note, the firm's default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. 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 Intel Corporation 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 Intel Corporation default risk responds to changes in 6 domestic risk factors and 5 international risk factors among the 26 world-wide macro factors used by the Federal Reserve in its 2013 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 89.2% of the variation in the default probability of Intel Corporation. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Intel Corporation can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the USA "semiconductor and equipment" sector, Intel Corporation has the following percentile ranking for its default probabilities among its 133 peers at these maturities:
1 month 83rd percentile
1 year 57th percentile
3 years 29th percentile
5 years 14th percentile
10 years 14th percentile
The short term ranking of Intel Corporation relative to its peers is high simply because business conditions are so good currently that they rank at the 89th percentile for the period from 1990 to the present. The strong corporate business conditions drive the default probabilities of all firms to low levels. Over a longer time horizon, Intel Corporation ranks in the safest quintile of its peer group from a credit risk perspective. Taking still another view, the actual and statistically predicted Intel Corporation credit ratings both show a rating strongly in the "investment grade" territory. The statistically predicted rating is 3 notches below the legacy rating.
We believe that a strong majority of sophisticated analysts would rank Intel Corporation as an investment grade company. The long run default probability outlook ranks in the best quintile of its peer group, and default probabilities have varied in a narrow band over the last decade. The company's stock purchases with debt late in 2012 have had a negative impact on default probabilities, but this negative impact has been relatively modest to date. We remind readers that a below average default probability is not sufficient reason to buy a bond. The bond must offer "good value," which we define in terms of the ratio of credit spread to the matching maturity default probability. By this measure, Intel Corporation bonds offer a fairly typical ratio of 4 basis points of credit spread for every 1 basis point of default probability. There are many other bonds in the market place offering a better risk to reward ratio, but Intel Corporation bonds are fairly priced and offer diversification to a bond investor who is already "full on the names" that offer a better reward to risk ratio.
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 firms mentioned in this article.