All too often, in discussions about the risk of municipal bond issuers, the credit default swap market is quoted as the source of information. In this note, we instead turn to the municipal bond market and actual traded prices to analyze the market view of the credit risk of the State of Illinois. This is particularly appropriate since the first lawsuit charging anticompetitive conduct in the credit default swap market was filed in the city of Chicago. A recent analysis by Kamakura Corporation showed that only 10 municipal or sub-sovereign entities had any credit default swap trades in the 155 weeks ended June 28, 2013. Illinois, which was one of the 10 municipals, averaged only 1.6 trades per day in the credit default swap market.
On average, only 25% of credit default swap trades have at least one non-dealer as a party to the trade, so only 0.4 trades per day in the State of Illinois credit default swaps are trades that involve an ultimate investor. The most recent week in which the Depository Trust & Clearing Corporation reported trades in the State of Illinois credit default swaps was the week ending December 6, 2013. During that week, there were only 10 trades for a notional principal amount of $50 million.
In this note, we analyze all of the trades from January 1 through December 17 on just one general obligation bond issued by the State of Illinois. The 5% bonds due January 1, 2018 were the largest tranche of the bonds issued March 3, 2010 by the State of Illinois. The remaining maturity on the bonds, just over 4 years, isn't too far off the standard 5 year maturity of 87% of all credit default swap trades.
The original issue documentation and current financial information is available from the EMMA website of the Municipal Securities Rulemaking Board ("MSRB"). That documentation states that the bonds are guaranteed by Assured Guaranty Municipal Corp., formerly known as Financial Security Assurance Inc. The bond insurance is described in the prospectus in this way on pages 6 and 7:
Assured Guaranty Limited (AGO) is listed on the New York Stock Exchange. Since January 1, 2013, its one and five year default probabilities have varied as shown in the following graph from Kamakura Risk Information Services:
For an explanation of how these default probabilities are determined, see the notes at the end of this article. Over the last year, the five year default probability for Assured Guaranty Limited has varied from about 0.13% to 0.27%. The current term structure of default probabilities for Assured Guaranty Limited is shown in this graph. The 5 year annualized default probability is 0.18% today:
In light of this guarantee, how is the market viewing the joint default risk of the State of Illinois and Assured Guaranty Mutual Corp., the indirect subsidiary of Assured Guaranty Limited? We turn to that now.
State of Illinois Municipal Bond Issue Yields and Credit Spreads
The MSRB website EMMA includes recent trading activity on a vast array of municipal bond issues in the United States. We use that data to derive the credit spreads of the 5.00% bonds due January 1, 2018 issued by the State of Illinois. From January 1 through December 16, in that one bond issue alone, there were 230 trades for a total principal value of $42.8 million of the 5.00% State of Illinois bonds due January 1, 2018. This is about one-third of the total principal amount of these bonds. The average trading volume per day on which trades occurred during this period was $487,000, with a daily high of $7.2 million and a low of $10,000. The total trading volume on all bonds issued by the State dwarfs the volume in the credit default swap market.
On each day for which a trade was reported, the yields to maturity for each trade were collected from the MSRB website. The remaining maturity of the bonds was calculated and the matched maturity U.S. Treasury yield was calculated using Treasury rate information from Kamakura Risk Information Services and the U.S. Department of the Treasury. The credit spread was calculated simply as the bond yields minus the matched maturity U.S. Treasury yields. We turn now to those results.
State of Illinois 5% Bonds due January 1, 2018
The evolution of yields to maturity and matched maturity Treasury yields on the 5.00% general obligation bonds due January 1, 2018 are shown in this graph:
The difference versus U.S. Treasuries, even with the guarantee, have shown a roller coaster pattern over the course of 2013. All trades during this period are reflected on this graph with no omissions or smoothing. For the readers' convenience, we have added a smooth line to the reported yields on the 5.00% bonds due January 1, 2018. The credit spreads themselves are shown in the next graph:
The highest spreads recorded from January 1 to December 16 were over 200 basis points. Spreads on December 16 ranged between 1.22% and 1.38% over matched-maturity U.S. Treasuries.
The credit spreads shown above for the State of Illinois 5.00% bonds reflect the default risk and related recovery associated both with the State itself and Assured Guaranty Municipal Corp. The parent, Assured Guaranty Limited, has an investment grade rating from legacy rating agencies. That being said, the statistically predicted rating is 3 notches lower and is barely inside the legacy definition of "investment grade," a term now re-defined by the Dodd-Frank Act as explained below.
We believe that the credit quality of Assured Guaranty Municipal Corp. is a topic that is very critical to a wide array of municipal bond issuers and muni investors, including those who have invested in the guaranteed bonds of the State of Illinois. The economics of mono-line insurers was well documented in this commentary by Dr. Robert Selvaggio on the Kamakura Corporation website. The risk of Assured Guaranty Municipal Corp. is no more diversified than the firms described in Dr. Selvaggio's essay.
We will examine the risk of the parent Assured Guaranty Limited in a forthcoming analysis. The credit spreads graphed above have a relationship to the default risk of Assured Guaranty Limited that is fairly typical. We document the spread-default probability relationships for a wide range of bond issuers in a series of recent studies. There do not seem to be many, if any, "Illinois-specific" risks in the credit spread above and beyond the risk of Assured Guaranty Municipal Corp. itself. That is what one would expect if the parent Assured Guaranty Limited were an exceptionally strong credit risk. The default probabilities, legacy ratings, and statistically predicted ratings of Assured Guaranty Limited are on the borderline of investment grade, however. The State of Illinois 5.00% bonds due January 1, 2018 are trading as if (A) the credit risk of Illinois is irrelevant because (B) Assured Guaranty Municipal Corp. is sure to pay in the event of a default by the State of Illinois. Investors who are not 100% sure of should not invest in the bonds of the State of Illinois at current spread levels.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the organization 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 organization 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.
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.
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."
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.