In this note we analyze the current levels and past history of default probabilities for Oracle Corporation (NASDAQ:ORCL), and we compare them to the credit spreads on secondary market trading in Oracle Corporation bonds on Friday, June 6, 2014. We compare our results to our earlier analysis of Oracle using data from July 12, 2013. Since our July 2013 report, Oracle CEO Larry Ellison engineered a miraculous come-back win in the America's Cup yacht race. Just a year earlier, he bought the Hawaiian island of Lanai in his spare time. This would be more than enough for most CEOs, but, since our July report, Oracle's financial strength has improved significantly in the eyes of financial markets. We review our findings in this report.
Conclusion: First, the default probabilities of the firm are low and they have become much stronger relative to peers since our July 2013 report. Second, traded credit spreads and matched-maturity default probabilities are very low compared to peers in technology, media and telecommunications and to the legacy investment grade peer group. We believe sophisticated analysts would be nearly unanimous in ranking Oracle Corporation as "investment grade" by the modern Dodd-Frank definition.
If there is any bad news in this report, it is that Oracle Corporation bonds are so expensive relative to their default risk that the credit spread to default probability ratio falls in the bottom third of all bonds that traded heavily on June 6, 2014. Investors who care about risk and return, rather than the brand, can choose from 195 other bonds that traded heavily on June 6, 2014 and offered a better reward to risk ratio than Oracle Corporation bonds.
Objectives of the Analysis
Our first objective is to answer whether or not Oracle Corporation 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 Oracle Corporation. We also measure the reward, in terms of credit spread, for taking on the default risk Oracle Corporation 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 Oracle 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. This graph shows the current default probabilities (in green) for Oracle Corporation ranging from one month to 10 years on an annualized basis. We compare them to the same default probabilities using in our July 12, 2013 analysis, graphed in yellow. Default probabilities range from 0.01% at 1 year (down 0.03% from July) to 0.22% at 10 years (down 0.04% from July).
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. On June 6, 2014, Oracle Corporation was the 27th most heavily traded issuer in the market for fixed rate corporate bonds in the United States:
Total trading in Oracle Corporation fixed rate bonds was 94 trades in 8 issues with a principal amount of $51.94 million traded. We used 90 trades in 7 issues with a principal amount of $49.6 million in this analysis after eliminating callable and non-senior debt issues.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Oracle 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, interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of Oracle Corporation. 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 Oracle Corporation 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 Oracle Corporation 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 Oracle Corporation above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm).
The high, low, average and fitted credit spreads at each maturity are graphed 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. This ratio of spread to default probability is shown in the following table for Oracle Corporation. At maturities under 2 years, the reward from holding the bonds of Oracle Corporation, relative to the matched maturity default probability, is almost 15 basis points of credit spread reward for every basis point of default risk. The ratio of spread to default probability decreases with maturity after that, falling to a credit spread to default ratio between 2.5 and 4.6 times. We compare these ratios to other bonds traded on June 6 below.
We show the same data from July 12, 2013 in this chart. The reward to risk ratios are roughly unchanged:
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.
Relative Value Analysis
Is the reward to risk ratio for Oracle Corporation 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 which traded at least $5 million in volume on June 6, 2014 and had at least 1 year to maturity. There were 297 bond issues that met our criteria. This histogram shows the distribution of credit spreads available in the market place.
The median credit spread was 0.826% and the average credit spread was 1.063%. The next graph shows the distribution of the credit spread to default probability ratio for all trades on June 6, 2014:
The median credit spread to default probability ratio was 7.299 and the average was 10.680. How did Oracle Corporation bonds rank among the 297 heavily traded bonds on June 6, 2014? The best placed Oracle Corporation bond ranked 196th, just barely better than the bottom third of all traded bonds. The other two heavily traded Oracle Corporation bonds ranked 200th and 212th on the day.
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 such on web pages like this one from the New York Stock Exchange.
Credit-Adjusted Dividend Yield
We explained in a recent post on General Electric Company (NYSE:GE) how default probabilities and the associated credit spreads for a bond issuer can be used to calculate the credit-adjusted dividend yield on a stock. That analysis makes use of a comparison between the yield on the issuer's promise to pay $1 in the future versus the yield on a similar promise by the U.S. government to pay $1 at the same time. Using the maximum smoothness approach to both the U.S. Treasury curve and to Oracle Corporation credit spreads, we can generate the zero coupon bond yields on their promise to pay $1 in the future, which are shown in this graph:
The widening of zero coupon credit spreads is important. If we discount dividend payments for maturities of 1, 10 and almost 30 years, we can solve for the "credit risk free" dividend for Oracle Corporation. This would be the dividend level for a default risk-free issuer (we assume as a first approximation that the U.S. Treasury is default risk-free) that has the same present value as the flow of dividends from Oracle Corporation over almost 30 years. We use this data from Seeking Alpha:
The history of Oracle Corporation dividends is nicely summarized on the company website.
Readers who prefer a real time update of the dividend yield information can see that here. After projecting the flow of dividends from Oracle Corporation at the quarterly rate of $0.12 and using the present value factors implied by Oracle Corporation bond prices, we find that the long-term credit-adjusted dividend yield is 1.001%, 0.122% less than the traditional dividend yield of 1.123% (note that the yield on the Seeking Alpha website is different because of lags in updating the figure as the stock price changes). Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that Oracle Corporation may default, ending the dividend stream. The bond-based discount factors incorporate this fact.
The first two years of cash flow assumed and discount factors used are shown here to illustrate the methodology:
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 30, 2014 (the most recent week for which data is available), the credit default swap trading volume on Oracle Corporation was as follows: 17 contracts traded during the week, representing a notional principal of $68.96 million, which ranked the company at number 631 among all reference names traded during the week. There were no trades that week on Oracle America, Inc., another legal entity on which credit default swaps are often traded.
The history of notional principal traded in the credit default swap market on Oracle Corporation is shown here:
Credit default swap contract trading volume, in numbers of contracts traded, is shown here:
Oracle America, Inc. notional principal trading history in the credit default swap market is shown in this graph:
The number of contracts traded on Oracle America, Inc. in the credit default swap market is shown here:
On a cumulative basis, the current default probabilities, graphed in green, for Oracle Corporation range from 0.01% at 1 year to 2.15% at 10 years. This is 0.03% and 0.45% lower than the July 12, 2013 default probabilities, graphed in yellow.
Over the last 10 years, the 1 year and 5 year default probabilities for Oracle Corporation have varied as shown in the following graph. The 5 year default probabilities peaked near 0.45%, while the 1 year default probabilities hit a maximum of 0.35% during this period. The five year default probabilities have been rising steadily in recent months.
The macro-economic factors driving the historical movements in the default probabilities of Oracle Corporation over the period from 1990 to the present include 6 factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These factors explain 30.6% of the variation in the 1 year default probability for Oracle Corporation. The remaining risk, which is substantial, is the idiosyncratic risk of the firm.
Oracle Corporation can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the US software and services sector, Oracle Corporation has the following percentile ranking for its default probabilities among its 469 peers at these maturities:
1 month 50th percentile, down 17 percentage points from July, 2013
1 year 14th percentile, down 29 percentage points
3 years 3rd percentile, down 14 percentage points
5 years 9th percentile, down 3 percentage points
10 years 9th percentile, down 3 percentage points
A comparison of the legacy credit rating for Oracle Corporation with the best available statistical estimates provided by Kamakura Corporation indicates that the company is overrated by four ratings grades. Over the last decade, the legacy credit ratings for Oracle Corporation have changed twice.
We review 4 key graphs before reaching our conclusions. We compare the credit spreads and matched maturity default probabilities for Oracle Corporation with two peer groups: the technology, media and telecommunications peer group and the legacy "investment grade" peer group as defined by traditional credit ratings. We look first at the sector peer group spreads on June 6, 2014:
Oracle Corporation credit spreads rank at the safest boundary of the sector peer group. Now we look at the matched maturity default probabilities for the peer group:
Again, Oracle Corporation ranks at the safest boundary of the peer group. Now we turn to the credit spreads on the investment grade peer group:
Again, Oracle falls at the safest end of the investment grade peer group. Turning to investment grade default probabilities, we get the same result for all bonds traded on June 6, 2014:
Our conclusions about Oracle Corporation bonds are easy to state. First, the default probabilities of the firm are low and they have become much stronger relative to peers since our July 2013 report. Second, traded credit spreads and matched-maturity default probabilities are very low compared to peers in technology, media and telecommunications and to the legacy investment grade peer group. We believe sophisticated analysts would be nearly unanimous in ranking Oracle Corporation as "investment grade" by the modern Dodd-Frank definition.
If there is any bad news in this report, it is that Oracle Corporation bonds are so expensive relative to their default risk that the credit spread to default probability ratio falls in the bottom third of all bonds which traded heavily on June 6, 2014. Investors who care about risk and return, rather than the brand, can choose from 195 other bonds that traded heavily on June 6, 2014 and offered a better reward to risk ratio than Oracle Corporation bonds.
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.