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Sep 22

Written by: Donald van Deventer
9/22/2014 8:23 PM 

This analysis is an updated bond market view of General Electric Company (GE), one of the most complex conglomerates in the world. General Electric completed the initial public offering of its credit card unit Synchrony Financial (SYF) in July, 2014. How does the bond market view General Electric and its key subsidiary General Electric Capital Corporation in light of the spin-off? We answer that question in this note.

We previously looked at General Electric Company onApril 7, 2014 This note uses the default probabilities and bond credit spreads of General Electric Capital Corporation, the financial services subsidiary of General Electric Company (GE), to measure the reward-to-risk ratio on the company’s bonds.

Conclusion: The 10 year cumulative default probability of the firm has dropped by 0.46% since our last report on April 7, 2014. This is impressive progress, and we believe the initial public offering of Synchrony Financial was a contributor to this improvement. The 0.15% funding advantage for General Electric Capital Corporation over its big bank competitors, as measured by the U.S. Dollar Cost of Funds Index, is important and somewhat surprising. This is consistent with the “brand name” premiums that investors typically pay for highly ranked brands like General Electric Company, ranked 7th on the Forbes list of most valuable brands. General Electric Company and General Electric Capital Corporation bonds have lower credit spreads and higher default probabilities that their peers in the investment grade and “banks/finance” group. Investors would have received better reward to risk ratios on 152 of those 186 issues than the most attractive General Electric Company and General Electric Capital Corporation bonds. 

The Analysis
This study is complicated by the fact that General Electric Company does not give an explicit guarantee on the bonds of General Electric Capital Corporation, a rare strategy among corporate bond issuers. Instead, it commits via an income maintenance agreement that the ratio of earnings to fixed charges at General Electric Capital Corporation will not fall below 1.1. Today’s study incorporates General Electric Capital Corporation bond price data as of September 19, 2014. A total of 706 trades were reported on 136 fixed-rate non-call bond issues of General Electric Capital Corporation with a single-day trade volume of $76.1 million. There was also trading in a few bond issues of General Electric Company itself on September 19 but we leave the comparison between the bonds of the two legal entities for another day.

We have three simple questions to answer in this analysis:

  • What maturities of General Electric Capital Corporation debt offer the most attractive ratio of credit spread to default risk?
  • How does the reward to risk ratio for General Electric Capital Corporation compare to the same ratio for other issuers?
  • Given the changes in the definition of “investment grade” mandated by the Dodd-Frank Act and described below, are the bonds issued by General Electric Capital Corporation investment grade or not?

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.

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. Kamakura Risk Information Services has an actively used non-public firm default probability model for non-public firms like General Electric Capital Corporation. In this note, however, we focus instead on the default probabilities of the parent company General Electric Company in light of the income maintenance agreement cited above. This assumption is somewhat more tenuous than it was in April in light of the spin-off of Synchrony Financial. The graph below shows the current default probabilities in blue for General Electric Company ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.14% at one month (down 0.02% from April) to 0.06% at 1 year (down 0.01%) and 0.34% at ten years (down 0.05%). The default probabilities on April 7, 2014 are shown in yellow. 



We explain the source and methodology for the default probabilities in regular posts on www.seekingapha.com. General Electric Company, via General Electric Capital Corporation, indirectly owns two FDIC insured banks. Using Kamakura’s U.S. Bank Default Probability Model, announced on September 9, 2014, we can see that both of these bank subsidiaries have 1 year default probabilities that are substantially higher than the ultimate parent company: 



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 all of the bond data mentioned above for the General Electric Capital Corporation fixed rate non-call issues in this analysis, with the exception of bonds with daily trade volume of less than $400,000, bonds with survivor options, and bonds for which reported pricing data appeared erroneous. The most heavily traded bond issuers on September 19, 2014 are shown here, with General Electric Capital Corporation ranked fifth. 



The graph below shows 6 different yield curves that are relevant to a risk and return analysis of General Electric Capital 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 General Electric Capital 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 line from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on General Electric Capital 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 General Electric Capital Corporation issue recorded by TRACE. The black dots and the black connecting line reflect the yield curve derived from fitting a cubic polynomial on a trade-weighted basis to the credit spreads of General Electric Capital Corporation. See below for details.

The liquidity premium built into the yields of General Electric Capital Corporation above and beyond the “default-adjusted risk free curve” (the risk-free yield curve plus the matched-maturity default probabilities for the firm) widens with maturity, the normal pattern for a high quality credit, although there are many outliers around this trend. 



The high, low and average credit spreads at each maturity are graphed below. The black line represents the fitted cubic polynomial designed to minimize fitting errors on a trade-weighted basis. Credit spreads are generally increasing with the maturity of the bonds. We have done nothing to smooth the data reported by TRACE, which includes both large lot and small lot bond trades. 



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 tables for General Electric Capital Corporation using the very important and optimistic assumption that the default probabilities of GECC are equal to those of General Electric Company. The ratio of credit spread to default probability generally ranges from 2 times to 6 times. 



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

 

Comparative Funding Cost Analysis
As a major competitor in the financial services business, General Electric Capital Corporation’s ability to raise funds at or below the cost of its banking competitors is a key success factor. The U.S. Dollar Cost of Funds Index TM measures the trade-weighted cost of funds for the largest deposit-taking U.S. bank holding companies. The index is a credit spread, measured in percent and updated daily, over the matched maturity U.S. Treasury yield on the same day. The current bank holding companies used in determining the index are Bank of America Corporation (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), and Wells Fargo & Company (WFC). The index is an independent market-based alternative to the Libor-swap curve that has traditionally been used by many banks as an estimate of their marginal cost of funds. Kamakura Corporation is the calculation agent, and the underlying bond price data is provided by TRACE and the U.S. Department of the Treasury. This graph compares the credit spreads of General Electric Capital Corporation with the U.S. Dollar Cost of Funds Index on September 19, 2014: 



On September 19, the bonds of General Electric Company and General Electric Capital Corporation were trading at credit spreads that averaged 0.15% below the composite cost of the big four banks underlying the U.S. Dollar Cost of Funds Index.

Relative Value Analysis
How do the ratios of credit spread to default probability for General Electric Capital Corporation compare with the ratios for other issuers? Are they high, normal, or low? The best way to answer these questions is to review this histogram of the credit spread to default ratio for all bond issues which traded at least $5 million on September 19, 2014. The median credit spread of the 186 trades was 0.965% and the average was 1.278%. 



The median credit spread to default probability ratio was 11.501. The average credit spread to default probability ratio was 17.376, as reflected in this graph: 



The next chart lists the best value bond trades for maturities of 1 year or more and trading volume of at least $5 million on September 19, 2014. A total of 152 of the 186 bond issues had a better ratio of credit spread to default probability than the best General Electric Company bond, ranked 153rd. The worst-ranking General Electric Capital Corporation bond was at 176th out of the 186 bonds that met our criteria. The three heavily traded bonds of General Electric Company, the parent, ranked 153, 159 and 169. 



CUSIPs
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently illegal under 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. This article neatly summarizes which institutions have restricted availability of CUSIPs in order to maximize their profits as a monopoly supplier of the data. Thanks to FINRA, the CUSIPs have been put into the public domain for free via this FINRA-affiliated website.

Credit-Adjusted Dividend Yield
We explained in another post on General Electric Company (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 General Electric Capital 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 General Electric Company. 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 General Electric Company over almost 30 years. We use this data from SeekingAlpha.com: 



The history of General Electric Company dividends is nicely summarized on the company website.

After projecting the flow of dividends from General Electric Company at the quarterly rate of $0.22 and using the present value factors implied by General Electric Capital Corporation bond prices, we find that the long term credit-adjusted dividend yield is 2.971%, 0.405% less than the traditional dividend yield of 3.376% (note that the yield on the SeekingAlpha 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 General Electric Company may default, ending the dividend stream. The bond-based discount factors incorporate this fact. We show the calculation below for just the first 24 months of cash flows. 

 

Insights from the Credit Default Swap Market
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended September 12, 2014 (the most recent week for which data is available), the credit default swap trading volume on General Electric Capital Corporation was 68 trades with $763.8 million of notional principal. General Electric Capital Corporation ranked 12th among all reference names in weekly credit default swap trading volume during the week. 



The next chart plots the number of credit default swaps traded on General Electric Capital Corporation since DTCC began releasing weekly trading volume in July 2010. 



The notional principal of credit default swaps traded weekly on General Electric Capital Corporation is shown here: 

 

Additional Analysis
On a cumulative basis, the default probabilities for General Electric Company, the parent, range from 0.06% at 1 year (down 0.01% from April) to 3.39% at 10 years (down 0.46% from April), as shown in the following graph. Current cumulative default probabilities are shown in blue. The April cumulative default probabilities are shown in yellow. 



Over the last decade, the 1 year and 5 year default probabilities for General Electric Company, the parent, have varied as shown in the following graph. The one year default probability peaked at just under 4.00% in the first half of 2009 during the worst part of the credit crisis. As we noted in our July 11, 2013 report, the General Electric family of companies was an active borrower under the Federal Reserve’s Commercial Paper Funding Facility during the credit crisis. General Electric Capital Corporation was also an active issuer of debt guaranteed by the FDIC during the credit crisis as noted above. 



In contrast to the daily movements in default probabilities graphed above, the legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO), for General Electric Company have changed only once during the decade. In the case of Standard & Poor’s, the General Electric Company ratings have changed only once since 1956. The best statistical estimates of the legacy credit rating provided by Kamakura Risk Information Services show a predicted rating 6 notches below the current legacy rating of General Electric Company, a high degree of “over-rating.”

The macro-economic factors driving the historical movements in the default probabilities of General Electric Company, the parent, 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 General Electric Company default risk responds to changes in 4 key factors among those listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 72.6% of the variation in the default probability of General Electric Company. The remainder of the variation in default probabilities, 27.4% of the total, is the idiosyncratic risk of the firm.

General Electric Company, the parent, can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the USA “capital goods” sector, General Electric Company has the following percentile ranking for its default probabilities among its 390 peers at these maturities:

1 month     81st percentile, up from the 78th percentile in April
1 year        60th percentile, unchanged from April
3 years      46th percentile, down from the 48th percentile
5 years      36th percentile, down from the 37th percentile
10 years    34th percentile, unchanged from April

The percentile ranking of General Electric Company default probabilities at one month through one year is in the riskiest half of the capital goods peer group. The percentile ranking for General Electric Company at 3 through 10 years is in the 2nd safest quartile of credit risk among capital goods firms.

Conclusions
As always in this series, our conclusions are based on facts from the marketplace, not the individual opinions of the author. We first compare General Electric Company and General Electric Capital Corporation to their sector peers, and then we make a comparison to investment grade firms.

For purposes of this comparison, we use the sector definition provided by MarketAxess. Unlike Morgan Stanley’s classification of General Electric Company in the “capital goods” sector, MarketAxess labels General Electric Company as being in the “banks/finance” sector. Relative to those peers whose fixed rate non-call bonds traded on September 19, General Electric Capital Corporation credit spreads were below the median as shown in this graph: 



When we plot the default probabilities of General Electric Company versus the default probabilities of the peer group whose bonds traded on September 19, the comparison is not nearly as favorable. General Electric Company default probabilities rank well above the median of the peer group. 



We now turn to a comparison of the credit spreads for all bonds traded on September 19 and issued by firms with a legacy classification of “investment grade” by the major rating agencies. The credit spreads of General Electric Capital Corporation are at or below the median in this chart: 



When we compare the default probabilities of General Electric Company with the matched-maturity default probabilities of the investment grade firms whose bonds traded on September 19, we again find General Electric Company at or above the median. 



Our conclusions about General Electric Company are much the same as the conclusions we reached in April: the firm is a complex credit. The 10 year cumulative default probability of the firm has dropped by 0.46% since our last report on April 7, 2014. This is impressive progress, and we believe the initial public offering of Synchrony Financial was a contributor to this improvement. The 0.15% funding advantage for General Electric Capital Corporation over its big bank competitors, as measured by the U.S. Dollar Cost of Funds Index, is important and somewhat surprising. This is consistent with the “brand name” premiums that investors typically pay for highly ranked brands like General Electric Corporation, ranked 7th on the Forbes list of most valuable brands.

While there is no doubt that a strong majority of analysts would rate the bonds of General Electric Capital Corporation as investment grade, the reward for bearing the risk of default or a larger spin-off from General Electric Company is well below the 11.5 median spread to default probability ratio of the 186 corporate fixed rate bond issues which traded more than $5 million on September 19, 2014. General Electric Company and General Electric Capital Corporation bonds have lower credit spreads and higher default probabilities that their peers in the investment grade and “banks/finance” group. Investors would have received better reward to risk ratios on 152 of those 186 issues than the most attractive General Electric Company and General Electric Capital Corporation bonds. 

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 SeekingAlpha, 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.

Copyright ©2014 Donald van Deventer

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