The iconic food retailer Safeway Inc. (SWY) is going through some turbulent times in spite of a default probability history and credit spread history that, in normal times, would be attractive. Safeway Inc. recently adopted a “poison pill” rights agreement after Jana Partners LLC acquired a 6.2% stake in the food retailer. In this note, we focus on the risk and return of the bonds issued by Safeway Inc. in light of these recent developments.
Today’s note incorporates Safeway Inc. bond price data as of September 20, 2013. A total of 206 trades were reported on 9 fixed-rate non-call bond issues of Safeway Inc. with trading volume of $25.3 million. All of this data was used in this study. We note below that credit default swap trading volume in Safeway Inc. was much heavier than the bond trading volume, a fairly rare phenomenon that generally indicates a significant difference of opinion regarding the forward-looking default risk of the company.
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 Safeway 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. The new rules delete references to legacy credit ratings and replace them with default probabilities as explained here.
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 Safeway 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 Safeway Inc. ranging from one month to 10 years on an annualized basis. For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The default probabilities range from 0.04% at one month to 0.02% at 1 year and 0.40% at ten years. These default probabilities are less than 1/50th as high as the default risk on bonds issued by an affiliate of Telecom Italia S.p.A., which has a legacy rating just one notch lower than Safeway Inc. Telecom Italia S.p.A. bonds were analyzed in this note posted last week.
We also 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 all of the bond data mentioned above for the 9 Safeway Inc. fixed rate non-call bond issues mentioned above.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Safeway Inc. 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 Safeway Inc. The next 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 orange line graphs the lowest yield reported by TRACE on that day on Safeway Inc. bonds. The green line displays the average yield reported by TRACE on the same day. The red line is the maximum yield in each Safeway Inc. issue recorded by TRACE.
The graph shows an increasing “liquidity premium” for holding the bonds of Safeway Inc. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below. We see 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. For the reader’s convenience, we fitted a cubic polynomial that explains the average spread as a function of years to maturity. This polynomial explains 92.6% of the variation in the average credit spread over the maturity term structure:
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. The ratio of credit spread to default probability for Safeway Inc. is well over 10 times for maturities less than 4 years. For maturities beyond that, the ratio is near 6.5 except for the 17 year bond, which has a spread to default probability of more than 9 times. This ratio of spread to default probability is shown in the following table for Safeway Inc.:
The credit spread to default probability ratios are shown in graphic form here. We have again added a cubic polynomial relating the credit spread to default probability ratio to the years to maturity on the underlying bonds. The smoothed line explains 85.21% of the variation in the reward to risk ratio.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended September 13, 2013 (the most recent week for which data is available), the credit default swap trading volume on Safeway Inc. was 73 trades for $429.5 million of notional principal. Safeway Inc. was the 56th most heavily traded name by notional principal in the CDS marketplace that week. The number of credit default swap contracts traded on Safeway Inc. in the 155 weeks ended June 28, 2013 is summarized in the following table:
Safeway Inc. ranked 47th among all reference names in weekly credit default swap trading volume during this period, which is graphed below:
On a cumulative basis, the default probabilities for Safeway Inc. range from 0.02% at 1 year to 3.96% at 10 years, a relatively modest cumulative probability of default compared to many firms analyzed in this series of bond studies.
Over the last decade, the 1 year and 5 year default probabilities for Safeway Inc. have been consistently volatile but they have been contained in a narrow range. The 1 year default probability peaked just short of 0.70% in 2003-2004. The five year default probability peaked recently at just over 0.45% in the same time period.
In contrast to the daily movements in default probabilities graphed above, we turn to the legacy credit ratings for Safeway Inc., those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO). These legacy ratings have changed only twice during the decade, more slowly than the median 815 days since the last rating change for rated companies found in a recent study by Kamakura Corporation.
The macro-economic factors driving the historical movements in the default probabilities of Safeway Inc. 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 Safeway Inc. default risk responds to changes in eight risk factors among the 26 factors listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review. These macro factors explain 73.6% of the variation in the default probability of Safeway Inc.:
Real gross domestic product
3 month U.S. Treasury bill yield
BBB-rated corporate bond yield
Home price index
Commercial real estate index
3 international risk factors
Safeway 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 “food and staples retailing” sector, Safeway Inc. has the following percentile ranking for its default probabilities among its 35 peers at these maturities:
|1 month||74th percentile|
|1 year||57th percentile|
|3 years||60th percentile|
|5 years||54th percentile|
|10 years||51st percentile|
The percentile ranking of Safeway Inc. default probabilities is higher than the median for its sector at all maturities. Taking still another view, the actual and statistically predicted Safeway Inc. credit ratings both show a rating just barely in “investment grade” territory. The statistically predicted rating is one notch below the legacy rating.
We believe that a majority of analysts would rate Safeway Inc. as investment grade. That assessment, however, depends heavily on the outcome of discussions with Jana Partners LLC and any subsequent changes in capital structure that may emerge from those talks. On a “business as usual basis,” we believe that the bonds of Safeway Inc. offer better than average value when measured in terms of the ratio of credit spread to default probability. From the perspective of a small institutional investor or a retail investor, the outcome of the Jana Partners LLC discussions constitutes a significant event risk that may not be diversifiable by smaller investors. Smaller investors should carefully consider whether their portfolio can tolerate an outcome unfavorable to Safeway Inc. bond holders, who are not directly protected by the poison pill granted to common shareholders.
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.