In this note, we take a second look at the bonds of another iconic American industrial company, Intel Corporation (NASDAQ:INTC). We first reviewed Intel Corporation on October 2, 2013. We seek to bring a more intense bond market perspective to the outlook for Intel Corporation in today's analysis. Today's note incorporates Intel Corporation bond price data as of February 3, 2014, although trading volume has dropped after the large bond issues launched in September and December of 2012. A total of 62 trades were reported on 7 fixed-rate non-call senior bond issues of Intel Corporation with trading volume of $9.85 million. We used all of that data in this note.
Conclusion: In our prior analysis we described Intel Corporation bonds as offering "fairly typical" reward to risk ratios. In today's analysis, we dig deeper and find that there were 239 bond trades done for $5 million or more on February 3, 2014 that offered a better ratio of credit spread to default probability than the best Intel Corporation bond trade on that day, 4.1 times. Only 42 large trades done on February 3, 2014 had lower credit spread to default ratios than the best ratio on Intel Corporation bonds. We still believe that Intel Corporation bonds offer "intelligent diversification" and reasonably low default risk, but only if an investor is "full" on a lot of other iconic names that we list below.
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. 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 (NYSE:C) bonds published December 9, 2013.
Assuming the recovery rate in the event of default would be the same on all bond issues of the same issuer, 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 (in green) for Intel Corporation ranging from one month to 10 years on an annualized basis versus the October 2, 2013 default probabilities (in yellow). 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 0.16% at one month (up 0.02% from October) to 0.07% at 1 year (up 0.01%) and 0.31% at ten years (down 0.02% from October).
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 6 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 exactly matches the maturity of the traded bonds of Intel Corporation. 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 yields reported by TRACE on that day on Intel Corporation bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day. The red dots show the maximum yield in each Intel Corporation issue recorded by TRACE. The black dots and connecting black line show the yield consistent with the best fitting trade-weighted credit spread explained below.
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 (in black) that explains the trade-weighted average spread as a trade-weighted function of years to maturity. The polynomial explains 97.47% 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 2.79 times to 4.11 times, a narrow range for the reward to risk ratio that is slightly lower than we reported for October 2, 2013. The ratios of spread to default probability for all traded bond issues are shown here:
The October 2, 2013 ratios are reproduced here:
The credit spread to default probability ratios are shown in graphic form below for Intel Corporation.
Are these reward to risk ratios "fairly typical" as we stated in the October 2, 2013 report? Are they above or below average? The best way to answer that question is to compare them to the credit spread to default probability ratios for all fixed rate non-call senior debt issues with trading volume of more than $5 million and a maturity of at least one year on February 3. Here is that comparison:
The black line connects the median levels of the credit spread to default probability ratio at various points on the maturity spectrum. The line varies because the issuers traded at each maturity point are different. Nonetheless, the dark blue dots representing the Intel Corporation credit spread to default probability ratios are either at or below the median at every point on the maturity spectrum.
239 out of 282 large trades on February 3 had better credit spread to default probability ratios than the best ratio for any of the Intel Corporation bonds. Here are the 50 "best trades" done February 3, 2014 that had the highest ratios of credit spread to default probability:
Credit Default Swap Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended January 24, 2014 (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 181 weeks ended December 27, 2013 is also zero according to a recent report on CDS trading volume from Kamakura Corporation. 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 0.07% at 1 year (up 0.01% from October) to 3.09% at 10 years (down 0.12% from October), a level of long term risk about 10 times higher than the level for Royal Bank of Canada which we analyzed on February 3, 2014.
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 10 risk factors among the 28 world-wide macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 87.99% 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 81st percentile, down 2 points since October
1 year 54th percentile, down 3 points
3 years 26th percentile, down 3 points
5 years 15th percentile, down 1 point
10 years 14th percentile, unchanged since October
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 92nd 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, those of Moody's and Standard & Poor's. The legacy credit ratings of Intel Corporation have never changed in the last decade.
Before reaching a final conclusion about the "investment grade" status of Intel Corporation, we look at more market data. First, we look at Intel Corporation credit spreads versus credit spreads on every bond in the technology, media, and telecommunications sector that traded on February 3:
Intel Corporation credit spreads were clearly lower than average for the peer group. We now look at the matched maturity default probabilities on those traded bonds for both Intel Corporation and the peer group:
The default probabilities for Intel Corporation are in the lower range of the industry peer group. We now turn to the legacy "investment grade" peers. First we compare traded credit spreads on February 3, 2014:
Again, Intel Corporation credit spreads are at the low end of the peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on February 3 are shown in this graph:
This comparison is not as favorable for Intel Corporation. It explains why Intel Corporation bonds rank so low in terms of the credit spread to default probability ratio. Intel Corporation credit spreads are low (because bond prices have been bid up relative to peers) but its default probabilities are not, squeezing the reward to risk ratio down to low levels.
We still 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 below average reward to risk ratio. This means that investors must pay a high price to include Intel Corporation bonds in their portfolio. Why would an investor do so? Only if the investor were full on the names that offer better value (say the 50 examples from February 3 shown above) or if the investors were full on the industry or macro factor exposures of the issuers offering a better reward to risk ratio.
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 firms mentioned in the article.