Today's analysis focuses on one of the few major financial institutions to emerge unscathed from the credit crisis of 2006-2010: Royal Bank of Canada (NYSE:RY). Today's note incorporates Royal Bank of Canada bond price data as of January 31, 2014. A total of 39 trades were reported on 11 fixed-rate non-call senior unsecured bond issues of Royal Bank of Canada with trading volume of $28.2 million. All of this data was used in this study.
Conclusion: Royal Bank of Canada bonds offer an excellent combination of low absolute default risk and well-above average value as measured by the credit spread to default ratio. We prove this with a comparison to all corporate non-call fixed rate senior debt issues on January 31.
Royal Bank of Canada Bond Analysis
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 Royal Bank of Canada to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. The default probabilities used are described in detail in the daily default probability analysis posted by Kamakura Corporation. The full text of the Dodd-Frank legislation as it concerns the definition of "investment grade" is summarized at the end of our analysis of Citigroup (C) bonds published December 9, 2013.
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 Royal Bank of Canada.
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 Royal Bank of Canada 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 current default probabilities (plotted in green) range from 0.00% at one month (0.000984% before rounding) to 0.00% at 1 year (0.001255% before rounding) and 0.03% at ten years. Royal Bank of Canada's 10 year default probability is less than one-third of that reported for Wal-Mart Stores Inc. in our January 22, 2014 study of that fine firm.
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 all of the bond data mentioned above for the 11 Royal Bank of Canada fixed rate non-call unsecured senior bond issues mentioned above.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Royal Bank of Canada 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 Royal Bank of Canada. 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 dots graph the lowest yield reported by TRACE on that day on Royal Bank of Canada bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day. The red dots represent the maximum yield in each Royal Bank of Canada issue recorded by TRACE. The black dots and connecting line are derived from fitting a trade-weighted cubic polynomial to Royal Bank of Canada average credit spreads.
The graph shows a generally increasing "liquidity premium" for holding the bonds of Royal Bank of Canada. We explore this premium in detail below.
The high, low, average and fitted credit spreads at each maturity are graphed below. We see 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. This polynomial explains 98.41% of the variation in the average credit spread over the credit spread term structure:
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. The average credit spread to default probability ratio is more than 25 for maturities less than 2 years. For maturities beyond that, the ratio is between 23 and 38, a much higher than average high ratio. This ratio of spread to default probability is shown in the following table for Royal Bank of Canada:
The credit spread to default probability ratios are shown in graphic form here:
What evidence is there to justify the statement that the return to risk ratio for Royal Bank of Canada is far above average? We analyzed the highest value bond trades of January 31 using these criterion:
Minimum maturity: 1 year
Maximum maturity: 5 years
Minimum daily trade volume:$5 million
We then ranked the trades in order by the credit spread to default probability ratio. We report the top 50 trades of the 176 trades that met the criterion above in this chart:
The Royal Bank of Canada bond trades with daily volume over $5 million ranked 30th and 32nd with reward to risk ratios of 25 and 24 respectively. These reward to risk ratios were more than triple the median ratio of 7.75 for all bond trades with more than $5 million in volume and maturities between 1 and 5 years on January 31.
Credit Default Swap Data
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. Royal Bank of Canada is not among the 1179 reference names on which credit default swaps have traded since the week ended July 16, 2010 according to a new study on CDS trading volume by Kamakura Corporation.
On a cumulative basis, the current default probabilities for Royal Bank of Canada range from 0.00% (after rounding) at 1 year to 0.31% at 10 years, again less than one-third of the default risk reported in our study of Wal-Mart Stores, Inc.
Over the last decade, the 1 year (in blue) and 5 year default probabilities (in yellow) for Royal Bank of Canada have never exceeded 0.14% at any time, even during the heart of the 2006-2011 credit crisis. Note, however, that the five year default probabilities have been rising slightly in recent months.
In contrast to the daily movements in default probabilities graphed above, we turn to the legacy credit ratings for Royal Bank of Canada, those reported by credit rating agencies like McGraw-Hill (NYSE:MHFI) unit Standard & Poor's and Moody's (NYSE:MCO). These legacy ratings have not changed even once during the decade, compared to the median 815 days since the last rating change for rated companies found in a recent study by Kamakura Corporation.
The macro-economic factors driving the historical movements in the default probabilities of Royal Bank of Canada 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 Royal Bank of Canada default risk responds to changes in nine risk factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 67.8% of the variation in the default probability of Royal Bank of Canada.
Royal Bank of Canada can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the world-wide "banks" sector, Royal Bank of Canada has the following percentile ranking for its default probabilities among its 263 peers at these maturities:
1 month 7th percentile
1 year 5th percentile
3 years 1st percentile
5 years 1st percentile
10 years 2nd percentile
The percentile rankings for the Royal Bank of Canada are exceptionally good. Taking still another view, the actual and statistically predicted Royal Bank of Canada credit ratings both show a rating strongly in "investment grade" territory. The statistically predicted rating is two notches below the legacy rating, however.
The results we have seen so far are exceptionally favorable for the Royal Bank of Canada and potential bond investors. Before reaching any conclusions about the "investment grade" status of Royal Bank of Canada, however, we first look at more data from the bond market. We exclusively use data from January 31, 2014. We first look at a comparison of credit spreads on traded Royal Bank of Canada bonds versus traded bonds in the same "Banks/Financials" sector:
Royal Bank of Canada trades at the very bottom of the peer group, on the safest end of the credit risk spectrum. We next look at the comparison of matched-maturity default probabilities for Royal Bank of Canada versus the same peer group for bonds traded January 31:
Again, Royal Bank of Canada compares extremely favorably to the peer group. We now turn to the larger data set of traded bonds among firms with a legacy rating consistent with the older definition of "investment grade." This graph shows that Royal Bank of Canada is trading at the bottom range (i.e., the best levels) of investment grade firms:
Matched-maturity default probabilities are also very low compared to the matched-maturity default probabilities on investment grade bonds traded January 31:
We believe that an overwhelming majority of analysts would rate Royal Bank of Canada as investment grade. The bank has been widely respected for its low level of credit risk for a long time. What is less well-known, however, is the fact the reward to bond holders per basis point of default risk is more than triple the median levels for all bond trades of $5 million or more in the 1-5 year maturity range on January 31. Royal Bank of Canada proves that one does not need to "chase yield" by going "down market" in credit risk terms. Indeed, Royal Bank of Canada offers a far superior reward to risk ratio than firms with higher yields as the January 31 data proves.
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.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.