Background to the Analysis of Dell Inc.
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 Dell Inc. to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which requires that credit rating references be eliminated from U.S. government regulations. Section 939A states the following:
“SEC. 939A. REVIEW OF RELIANCE ON RATINGS.
(a) AGENCY REVIEW.—Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review—
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(b) MODIFICATIONS REQUIRED.—Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(c) REPORT.—Upon conclusion of the review required under subsection (a), each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection (b).
The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:
“In this rulemaking, the OCC has amended the regulatory definition of ‘investment grade’ in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is ‘investment grade,’ banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution’s risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised ‘investment grade’ standard.”
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 Dell Inc.
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 Dell Inc. ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.29% at one month (down 0.07% from July 23) to 0.14% at 1 year (down 0.03%) and 0.80% at ten years (up 0.02%). The green line represents the current default probabilities and the yellow line represents the default probabilities as of our prior report, which used data for July 23, 2013.
We 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 TRACE data described above in today’s analysis.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Dell Inc. bonds. The lowest curve, in dark blue, is the yield to maturity on the benchmark U.S. Treasury bonds interpolated to match the maturity of the traded bonds of Dell Inc. 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 line from the bottom (in orange) graphs the lowest yield reported by TRACE on that day on Dell Inc. bonds. The fourth line from the bottom (in green) displays the average yield reported by TRACE on the same day. The highest yield (in red) is obviously the maximum yield in each Dell Inc. issue recorded by TRACE.
The data makes it very clear that there is a very large liquidity premium built into the yields of Dell Inc. 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 and average credit spread at each maturity are graphed below. While there is a fair amount of volatility in spread prevailing on the shorter maturities, credit spreads are gradually increasing with the maturity of the bonds. For the convenience of the reader, we have added a smoothed line fitted to average credit spreads below.
Because we have 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 Dell Inc. At all maturities, the reward from holding the bonds of Dell Inc., relative to the matched maturity default probability, is above average and up to ratios of 5 to 9 beyond 5 years in maturity compared with the 4 to 7 ratio levels found in our previous report.
The next graph plots the ratio of credit spread to default probability at each maturity. Again, we have added a smoothed line to the average spread to default probability ratio.
For Dell Inc., the spread to default probability ratios are above average across the board, which is appropriate given the potential changes in capital structure under the new Dell Inc. ownership. After some volatility at the shorter maturities, the reward for bearing a basis point of default risk declines from levels of over 10 times to ratios generally in the 5 to 9 times default risk range.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended October 11, 2013 (the most recent week for which data is available), the credit default swap trading volume on Dell Inc. showed 26 contracts trading with a notional principal of $123.7 million. This compares with 68 contracts traded for a notional principal of $390.6 million in our last report. For the 155 weeks ended June 28, 2013, the statistics for credit default swap trading on Dell Inc. are shown here:
Compared to more than 1,000 other reference names, Dell Inc. ranked 116th in trading volume depicted in the following graph:
On a cumulative basis, the current default probabilities for Dell Inc. have twisted from our July report. The current cumulative default probabilities, shown in green, range from 0.14% at 1 year (down 0.03%) to 7.72% at 10 years, up 0.20% from our July report. Cumulative default probabilities as of July are shown in yellow.
Over the last 10 years, the 1 year and 5 year default probabilities for Dell Inc. have varied as shown in the following graph. The one year default probability peaked at over 1.30% and the 5 year default probability peaked over 0.50% in the first half of 2009. This is a modest peak level compared to many of the world’s largest financial institutions during the same period.
Over the same decade, the legacy credit ratings (those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO) for Dell Inc. have changed four times.
The macro-economic factors driving the historical movements in the default probabilities of Dell Inc. over the period from 1990 to the present include the following factors of those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
BBB-rated corporate bond yields
30 year fixed rate mortgage yields
The Dow Jones Industrials stock price index
Commercial real estate price index
5 international macro factors
These macro factors explain 74.9% of the variation in the default probability of Dell Inc. since 1990.
Dell Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the USA technology, hardware and equipment sector, Dell Inc. has the following percentile ranking for its default probabilities among its 320 peers at these maturities:
79th percentile, down 4 percentiles since July
63rd percentile, down 2
45th percentile, down 2
36th percentile, up 1
32nd percentile, up 1
Dell Inc. is in the bottom half of creditworthiness among its peers for maturities of one year or less. Dell Inc. ranks in the 2nd quartile by riskiness for maturities from 3 to 10 years. A comparison of the legacy credit rating for Dell Inc. with predicted ratings indicates that the company is rated 3 notches higher by statistical methods than by the traditional “expert judgment” system of the legacy rating agencies.
Dell Inc. has experienced fairly minimal variation in its default probabilities over the last decade, particularly in comparison with financial institutions. Current default probabilities are fairly high, however, and they reflect both an increased risk of a more aggressive capital structure under Michael Dell and Silver Lake Partners and a substantial upheaval in Dell’s core markets. At current default probability levels, we believe that a slim majority of sophisticated analysts would rate Dell Inc. “as is” as investment grade by the Comptroller of the Currency definition, but it would be ranked near the bottom of the investment grade range. On a forward looking basis, the outlook for Dell Inc. depends on the action of Michael Dell and a few others. That is a judgment for each investor to make. This author declines to predict the actions of any individual human being other than Santa Claus, and, even in that case, only on Christmas Eve.
Background on Default Probabilities Used
The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model 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 data base. An overview of the full suite of related 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.