Deutsche Bank AG Bonds: Good But Not Great

Jun. 2.14 | About: Deutsche Bank (DB)

Summary

Deutsche Bank is one of the world's leading global banks and the German market leader.

The bank's default probabilities are high relative to peers, and it would take a 33% stock price rise to bring default risk to peer levels.

Ranked by the credit spread to default probability measure, the bank's bonds trade in the top 45% of the value ranking. Good, but not great.

Deutsche Bank AG (NYSE:DB), founded in 1870, is a leading global bank and the leader in its home market, Germany. Investors in North American financial institutions seem overly-focused on names like Bank of America (NYSE:BAC), which has 28 times the retail following than Deutsche Bank AG. That disparity often spells opportunity, so we ask the question, "What is the current bond market view of Deutsche Bank AG?" Today's study incorporates 60 May 30 bond trades on 9 U.S. dollar bonds issued by Deutsche Bank AG (London Branch) with trading volume of $31.6 million. We use this bond price data to analyze the potential risk and return to bondholders and common shareholders of Deutsche Bank AG. We also comment on the counterparty credit risk insights that one can derive from the same data, particularly from the bank's zero coupon credit spreads.

Conclusion: The peer group rankings of Deutsche Bank AG default probabilities are surprisingly high. Deutsche Bank AG is one of the few major financial institutions for which the short-run maturities offer substantially less reward, as measured by the credit spread to default probability ratio, than the long-run maturities. That being said, the bank's bonds rank in the top 45% of the 614 bond issues that traded heavily on May 30. We believe a strong majority of sophisticated analysts would label the bank as "investment grade" under the modern Dodd-Frank definition. That being said, the Bank of Nova Scotia (NYSE:BNS), with 10 year cumulative default risk just one-fifth of Deutsche Bank's, is a strong credit that Deutsche Bank AG would do well to emulate.

Analytical Objectives

Our first objective is answer whether or not Deutsche Bank AG would be considered "investment grade" in light of the changed definition of investment grade mandated by the Dodd-Frank Act and recently implemented by the Office of the Comptroller of the Currency. For background on Dodd-Frank and related regulatory changes, see our December 6 analysis of Citigroup Inc. (NYSE:C).

In this note we analyze the current levels and past history of default probabilities for Deutsche Bank AG. We also measure the reward, in terms of credit spread, for taking on the default risk of Deutsche Bank AG bonds.

Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority for 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 maturities where the credit spread to default probability ratio is highest for Deutsche Bank AG.

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 Deutsche Bank AG ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.58% at one month to 0.27% at 1 year and 0.20% at ten years. The downward sloping credit spread curve is fairly unusual. It normally is seen at firms where there is higher risk in the short term than the longer term. A stress test of the Deutsche Bank AG default probabilities indicates that a 33% rise in the bank's stock price would lower short run default probabilities to levels more typical of Deutsche Bank's peers.

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We explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation on Seeking Alpha.

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 bond data mentioned above for the 9 Deutsche Bank AG (London Branch) fixed rate non-call issues in this analysis.

The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Deutsche Bank AG 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 Deutsche Bank AG. The second lowest 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 third curve from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on Deutsche Bank AG bonds. The fourth line from the bottom (the green dots) displays the average yield reported by TRACE on the same day. The highest yield (the red dots) is obviously the maximum yield in each Deutsche Bank AG issue recorded by TRACE. For the reader's convenience, we have added a trade volume-weighted credit spread, fitted to the trade-weighted average credit spread at each maturity. This curve is shown as black dots joined by black line segments.

The data makes it clear that there is a steady liquidity premium built into the yields of Deutsche Bank AG above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm). The liquidity premium changes from negative in the very short run to an increasingly widening premium.

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The high, low and average credit spreads at each maturity are graphed below. Click to enlarge

The zero coupon credit spreads and zero coupon bond yields for Deutsche Bank AG are shown in this graph versus zero coupon U.S. Treasury yields. We showed in a recent note on General Electric Company (NYSE:GE) how we can restate the dividend yield on a credit-adjusted basis. We leave that to the reader. Another important use of these zero coupon credit spreads is the assessment of the counter-party credit risk of Deutsche Bank, with whom another institution might have trades settling in 1, 2, or more days. By discounting the cash owed by Deutsche Bank at the zero coupon yields shown below, the analyst has a mark-to-market indicator of the costs of dealing with a counterparty whose default risk is not zero. Since there are no risk-free counterparties in today's world, this is an important calculation.

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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. This ratio of spread to default probability is shown in the following table for Deutsche Bank AG. At maturities under 1 year, the reward from holding the bonds of Deutsche Bank AG, relative to the matched maturity default probability, is very low: 0.467 to 1.39 basis points of credit spread reward for every basis point of default risk. The ratio of spread to default probability increases with maturity after that, rising to a credit spread to default ratio between 1.79 and 8.79 times.

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The credit spread to default probability ratios are shown in graphic form here. We have again added a traded-weighted polynomial (shown in black) relating the fitted credit spread-default probability ratio to the years to maturity on the underlying bonds.

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Relative Value Analysis

Is the reward to risk ratio for Deutsche Bank AG higher than average, lower than average, or just average? Rather than guess, we simply look at the facts. The chart below shows the credit spreads for all fixed rate senior non-call debt issues that traded at least $5 million in volume on May 30, 2014 and had at least 1 year to maturity. There were 614 bond issues that met our criteria. The median credit spread was 0.827% and the average credit spread was 1.15%. This histogram shows the distribution of credit spreads available in the marketplace.

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The next graph shows the distribution of the credit spread to default probability ratios for all 614 issues. The median ratio was 4.21 and the average ratio was 10.11.

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How did Deutsche Bank AG rank on May 30, 2014? There were 199 bond issues that offered a better credit spread to default ratio than the best ranked Deutsche Bank AG bond. The two Deutsche Bank AG bonds that traded at least $5 million were ranked 200 and 272 on the "best value" rankings of these 614 bond issues. Deutsche Bank AG clearly is in the top 45% of all traded bonds by our "best value" definition, the ratio of credit spread to default probability.

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CUSIPs

Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently prohibited by Kamakura Corporation's contract with the data vendor. We are working hard to change this so that we may make CUSIPs available in the future. In the meantime, CUSIPs for major issuers can be found easily with an internet search on web pages like this one from the New York Stock Exchange.

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 May 23, 2014 (the most recent week for which data is available), the credit default swap trading volume on Deutsche Bank AG was $342,358,784 in notional principal on 42 trades, ranking the bank as 56th for the week. Weekly data from the DTCC from July 2010 onward results in this graph of the notional principal traded in credit default swaps on Deutsche Bank AG.

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The number of contracts traded by week over the same period are shown in this graph:

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Additional Analysis

On a cumulative basis, the current default probabilities for Deutsche Bank AG range from 0.27% at 1 year to 1.96% at 10 years, as shown in the following graph. The 10 year cumulative default probability for Deutsche Bank AG is approximately 5 times that of Bank of Nova Scotia (BNS), which we analyzed in a recent note.

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Over the last decade, the 1 year and 5 year default probabilities for Deutsche Bank AG have varied as shown in the following graph. The one year default probability peaked at just under 3.50% in the first half of 2009 during the worst part of the credit crisis. The 5 year default probability (annualized) peaked at just over 1.00%.

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The macro-economic factors driving the historical movements in the default probabilities of Deutsche Bank AG 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 Deutsche Bank AG default risk responds to changes in 11 factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 72.9% of the variation in the default probability of Deutsche Bank AG. The remainder of the risk is the idiosyncratic default risk of Deutsche Bank AG.

Deutsche Bank AG 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 "diversified financials" sector, Deutsche Bank AG has the following percentile ranking for its default probabilities among its 1,740 peers at these maturities:

1 month 96th percentile,

1 year 85th percentile

3 years 77th percentile

5 years 49th percentile

10 years 33rd percentile

The percentile ranking for Deutsche Bank AG is very high for maturities of 3 years and under.

The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor's and Moody's (NYSE:MCO), for Deutsche Bank AG have changed four times in the last decade. A comparison of the legacy credit rating for Deutsche Bank AG with predicted ratings indicates that the statistically predicted rating is one notch lower than the actual legacy credit rating. Both the actual and predicted ratings are in the middle of the investment grade range.

Conclusions

Before reaching any conclusions about investment grade status, it is useful to look at some additional market views of Deutsche Bank AG and its peers. The following graph compares the traded credit spreads on Deutsche Bank AG with the traded credit spreads on the "Banks/Finance" peer group on May 30, 2014:

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The credit spreads for Deutsche Bank AG were near the median spreads in the peer group. We now look at the matched-maturity default probabilities for Deutsche Bank AG versus that same peer group. Deutsche Bank AG default probabilities are also near or slightly below the peer group median. We remind the reader that the bonds that trade in the secondary market are typically the strongest credits in any given peer group, so this is a stricter standard than the percentile rankings we gave above.

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We now compare the traded credit spreads for Deutsche Bank AG with the traded spreads for every firm with a legacy credit rating in the old-style "investment grade" range. Again, Deutsche Bank AG spreads are at or below the median.

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By the matched maturity default probability criterion, comparing to investment grade firms with bond trades on May 30, Deutsche Bank AG's default probabilities are above the median of the investment grade peer group on short maturities and near the median on longer maturities.

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With this data in mind, we draw some dispassionate conclusions. The peer group rankings of Deutsche Bank AG default probabilities are surprisingly high. As mentioned above, a one-third rise in the bank's share price would bring the short-run default probabilities into line with peers. Until this happens, Deutsche Bank AG is one of the few major financial institutions for which the short-run maturities offer substantially less reward, as measured by the credit spread to default probability ratio, than the long-run maturities. That being said, the bank's bonds rank in the top 45% of the 614 bond issues that traded heavily on May 30. With respect to investment grade status, we believe the long-run outlook for the bank's default probabilities is strong enough to lead a strong majority of sophisticated analysts to label the bank as "investment grade" under the modern Dodd-Frank definition. That being said, we believe that the default probabilities for Deutsche Bank AG put the bank in a category that deserves special monitoring. The Bank of Nova Scotia, with 10 year cumulative default risk just one-fifth of Deutsche Bank's, is a strong credit that Deutsche Bank AG would do well to emulate.

Author's Note

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.