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Donald R. Van Deventer, Ph.D.

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura.

# General Electric Capital Corporation Bonds: Bigger is not Better

12/18/2013 12:29 PM

This analysis is a fresh look at General Electric Company, one of the most complex conglomerates in the world. General Electric Company continues to be opportunistic in the financial services business, such as the December acquisition of $2.3 billion of commercial real estate loans from DeutschePostbank. In November, the Company announced plans for a partial initial public offering of its North American retail finance business in 2014. We most recently looked at General Electric Company on September 4, 2013. We also analyzed the risk of General Electric Company bonds on July 11, 2013. Given the announced plans for an eventual exit of its North American retail finance business, a review of the market’s assessment of General Electric Company is in order. 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. With a partial spin-off of General Electric Capital Corporation in the works, the risk for the bondholders of GECC become murkier still. We reach a simple conclusion in this note: investors can earn a much higher spread to default probability ratio on the bonds of other issuers. This study is complicated by the fact that General Electric Company does not give an explicit guaranty 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 December 17, 2013. A total of 1,251 trades were reported on 196 fixed-rate non-call bond issues of General Electric Capital Corporation with a single-day trade volume of$221.6 million.  There was also trading in a few bond issues of General Electric Company itself on December 17 but we leave the comparison between the bonds of the two legal entities for another day.

We have two 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?
• 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?

The question “should I buy or sell a given bond of GECC?” is the type of this question that this author intentionally does not answer.  Please consult your financial adviser in that regard.

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 September in light of the announced spin-off of the North American retail finance business. The graph below shows the current default probabilities in green for General Electric Company ranging from one month to 10 years on an annualized basis.  The default probabilities range from 0.10% at one month (down 0.08% from September) to 0.04% at 1 year (down 0.03%) and 0.37% at ten years (down 0.01%).  The default probabilities on September 3, 2013 are shown in yellow.

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 all of the bond data mentioned above for the General Electric Capital Corporation 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 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) is very erratic, particularly on the short end of the curve.  The credit spreads are particularly erratic for maturities under 6 years. The credit spreads generally widen with maturity, the normal pattern for a high quality credit, although there are many outliers around this trend.

The same data for September 3, 2013 is shown below in a slightly different format.

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.

The same data for September 3, 2013 is shown in the next graph:

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 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. At short maturities, the credit spread to default probability ratio varies wildly, from about 1.5 times to more than 20 times. The ratio of spread to default probability decreases once the maturity of the bonds exceeds 5 years, falling to a spread to default ratio between 3 and 5 times.  This reward to risk ratio is among the lowest of any firm analyzed in this series of bond studies, even though we are using the optimistic assumption that General Electric Capital Corporation is no more risky than General Electric Corporation.  By comparison, in our recent note on Citigroup, Inc., the reward-to-risk ratio was as much as six times higher than we are finding for General Electric Capital Corporation.

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.

The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name.  For the week ended December 13, 2013 (the most recent week for which data is available), the credit default swap trading volume on General Electric Capital Corporation was 113 trades with $931.6 million of notional principal, roughly the same on a daily basis as the$221.6 million bond trading volume on December 17. The number of credit default swap contracts traded on General Electric Capital Corporation in the 155 weeks ended June 28, 2013 is summarized in the following table:

General Electric Capital Corporation ranked 16th 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 General Electric Company, the parent, range from 0.04% at 1 year (down 0.03% from September) to 3.61% at 10 years (down 0.12% from September), as shown in the following graph.  Current cumulative default probabilities are shown in green.  The September 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 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 the following factors among those listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review:

• Change in real gross domestic product
• 3 month U.S. Treasury bill rates
• 10 year U.S. Treasury yield
• The VIX volatility index

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 399 peers at these maturities:

 1 month 76th percentile, down from the 79th percentile in September 1 year 56th percentile, down from the 66th percentile 3 years 39th percentile, down from the 50th percentile 5 years 35th percentile, down from the 38th percentile 10 years 33rd percentile, down from the 35th percentile

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, despite the fact that percentile rankings have improved since September. 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. Taking still another view, both the actual and statistically predicted General Electric Company credit ratings are “investment grade” by traditional credit rating standards of Moody’s Investors Service and the Standard & Poor’s affiliate of McGraw-Hill.  The bad news is that the statistically predicted rating is six notches below the legacy rating, making General Electric Company one of the most over-rated companies in the United States. The statistically predicted rating is in the bottom half of the investment grade range.

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 December 17, General Electric Capital Corporation credit spreads were at or slightly below the median as shown in this graph:

Sector peer default probabilities

When we plot the default probabilities of General Electric Company versus the default probabilities of the peer group whose bonds traded on December 17, 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 December 17 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 December 17, 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 September: the firm is a complex credit.  Its financial services subsidiary General Electric Capital Corporation is more complex still. The viability of a financial services firm that relies completely on wholesale markets for funding is questionable, and we therefore applaud the decision to spin-off the funding-intensive North American retail finance business.  During the last twenty years, many famous names have abandoned the wholesale funding business model either voluntarily or involuntarily, through merger or failure: Industrial Bank of Japan, Long-term Credit Bank of Japan, Nippon Credit Bank, Continental Illinois, First Chicago, Bankers Trust, and J.P. Morgan. Given the riskiness of the wholesale funding strategy, it remains remarkable that the parent company General Electric Company has determined that a lukewarm income maintenance agreement with General Electric Capital Corporation is the strongest credit support it is willing to give.

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 below average compared to other firms featured in this series of notes.  Spreads are below average and default probabilities are above average compared to both industry peers and investment grade peers. Investors can earn a much higher spread to default probability ratio on the bonds of other issuers.

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.

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.

Background on the Dodd-Frank Act and the Meaning of “Investment Grade”

Section 939A of the Dodd-Frank Act 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.”