RadioShack Corporation (NYSE:RSH) made a dramatic announcement that it was closing 1,100 locations on March 4, 2014. One news story describes RadioShack as being on the brink of default. Other analysts recently recommended the purchase of RadioShack bonds. In this note, we look at the view of RadioShack Corporation from a bond market perspective in light of Tuesday's news. On March 4, 2014, the 6.75% bonds due May 15, 2019 issued by RadioShack Corporation were traded 81 times on an underlying principal amount of $29.7 million. We use this limited set of data along with default probabilities and credit default swap trading volume to bring more facts to potential punters in the bonds.
Conclusion: The reward to risk ratio for RadioShack Corporation falls far short of fair compensation for the risk of holding the bonds. The firm ranks only 390th out of the 408 bond issues, which traded on March 4, 2014 when measured by the credit spread to default probability ratio. This trade makes sense only for those who have special (legal) insights on the risk and timing of those risks that RadioShack Corporation faces.
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. TRACE reports that the yields on the 6.75% bonds due May 15, 2019 varied on March 4, 2014 from a low of 18.61% to a high of 21.56%, with a trade-weighted average of 20.38%. The price of the bond traded in a range from 55.00 to 61.54, with a trade-weighted average of 57.55. Clearly, RadioShack Corporation is in severe distress. From a high-yield investor's perspective, is the reward worth the high risk? We explore that question now.
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. We analyze the credit spread/default probability ratio for RadioShack Corporation compared to competing investments on March 4, 2014.
Maximizing the ratio of credit spread to matched-maturity default probabilities requires that default probabilities be available at a wide range of maturities. In the wake of the March 4 announcement by RadioShack Corporation, the one year default probability (in blue) of the firm jumped by 1.93% to 5.53% on an annualized basis. The annualized one month default probabilities are shown in yellow.
The graph below shows the current default probabilities (in green) for parent RadioShack Corporation ranging from one month to 10 years on an annualized basis. The default probabilities range from 1.18% at one month to 5.53%% at 1 year and 12.88% at ten years. The yellow line is the term structure of default for RadioShack Corporation on March 3, 2014. Yesterday's announcement drove up default risk for the full-term structure of default risk.
We next display the cumulative probabilities of default for RadioShack Corporation. It is not a pretty picture. The most accurate Kamakura default probability model, the Jarrow-Chava version 5 model, shows a 74.81% cumulative probability of default for RadioShack over a 10-year horizon. The 5-year cumulative probability of default is 40.60%.
We also explain the source and methodology for the default probabilities below.
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 RadioShack Corporation, the credit spread to default probability is only 1.885. This is a very low level for the reward to risk ratio. The ratios of spread to default probability for the best 20 traded bond issues (fixed rate, senior debt, non-call) with daily volume of $5 million or more are shown here, along with the RadioShack Corporation bonds. The 6.75% RadioShack bonds rank only 390th out of 408 traded bond issues, when ranked by the credit spread to default probability ratio. This is because the average RadioShack Corporation credit spread of 18.776% on March 4 was paired with a matched maturity default probability of 9.96%. The 1.885 reward to risk ratio pales in comparison to the median of 9.85 and the average of 16.54 for all 408 bond issues traded on March 4 in volumes of $5 million or more.
The reward to risk ratio for RadioShack Corporation falls far short of fair compensation for the risk of holding the bonds. The firm ranks only 390th out of the 408 bond issues, which traded on March 4, 2014 when measured by the credit spread to default probability ratio. This trade makes sense only for those who have special (legal) insights on the risk and timing of those risks that RadioShack Corporation faces.
Credit Default Swap Trading Volume Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended February 28, 2014 (the most recent week for which data is available), the credit default swaps of RadioShack Corporation traded for a notional principal amount of $203.9 million in 49 trades.
The graph of the gross weekly number of contracts traded on RadioShack Corporation since July 2010 is shown here:
The notional principal of credit default swap trading on RadioShack Corporation over the same period is shown in this graph:
Background on the Default Probability Models Used
The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model (abbreviated KDP-jc5) 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 database. KRIS covers 35,000 firms in 56 countries, updated daily. Free trials are available at Info@Kamakuraco.com. An overview of the full suite of Kamakura 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.
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Kamakura Corporation has business relationships with a number of firms mentioned in the article.