Transocean Ltd. (RIG) helps customers find and develop oil and natural gas reserves. On July 15, Transocean Ltd.’s fully guaranteed finance subsidiary Transocean Inc. was the 12th most heavily traded issuer of senior fixed rate debt in the United States bond market. In this note, we turn to the U.S. dollar bonds issued by Transocean Ltd. and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on July 15, 2014. A total of 70 trades were reported on 9 fixed-rate bond issues of Transocean Ltd. with July 15 trading volume of $56.1 million.
We use this information for three purposes: to evaluate the risk and return on the firm’s bonds, to evaluate the firm’s credit risk-adjusted dividend yield, and to reach a conclusion on investment grade status by the modern “Dodd-Frank” definition.
Conclusion: We believe that the sentiment of sophisticated analysts on investment grade status for Transocean Inc. and Transocean Ltd. is at best a coin flip. The Company’s default risk has fallen over the last six months but it remains in the bottom 30% of the energy peer group. From a “good value” point of view, Transocean Inc. bonds fall in the bottom 15% of the heavily traded bond universe when ranked by the ratio of credit spread to default probability. We strongly discourage small investors from buying these bonds. The primary investor base for Transocean Inc. bonds should be those with very special insights into the off-shore drilling industry and those Wall Street bonus babies for whom a skewed bonus system creates a silk purse from a sow’s ear.
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 Transocean Ltd. and Transocean Inc. to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. For a discussion of the implications of the Dodd-Frank Act on the definition of investment grade, see our post on Citigroup in December.
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. In this note, we also analyze the maturities where the credit spread to default probability ratio is highest for Transocean Ltd. and Transocean 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 Transocean Ltd. (green line) ranging from one month to 10 years on an annualized basis. We plot the current default probabilities versus the default probabilities for Transocean Ltd. six months earlier on January 15, 2014 (orange line). For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. We also make the optimistic assumption that the default probabilities of Transocean Inc. are identical to those of the parent Transocean Ltd. The current Transocean Ltd. default probabilities range from 0.38% at one month to 0.35% at 1 year and 0.94% at ten years. Regular readers of these notes will recognize that this is a much higher level of default risk than we typically see among heavily traded bond issuers.
We also explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation on www.SeekingAlpha.com.
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. The total of all fixed rate debt issued by Transocean Inc. and traded on July 15 is reported here. Transocean Inc. was the 12th most actively traded issuer.
We used all of the Transocean Inc. trade information in this note.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Transocean 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 (TLT)(TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of Transocean 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 Transocean Inc. bonds. The green line displays the value-weighted average yield reported by TRACE on the same day. The red line is the maximum yield in each Transocean Inc. bond issue recorded by TRACE. The black dots and connecting black line represent the yields consistent with a trade-weighted fitted credit spread we discuss below.
The graph shows an increasing “liquidity premium” as maturity lengthens for the bonds of Transocean Inc. This increasing liquidity premium is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.
The high, low, average, and fitted credit spreads at each maturity are graphed below for Transocean Inc. We have done nothing to smooth the data reported by TRACE (other than eliminating erroneous data as explained above), which includes both large lot and small lot bond trades. For the reader’s convenience, we fitted a trade-weighted cubic polynomial that explains the average spread as a function of years to maturity.
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. For Transocean Inc., the credit spread to default probability ratio ranges from 1.7 to 3.1 times. The ratios of spread to default probability for all traded bond issues are shown here:
The credit spread to default probability ratios are shown in graphic form below for Transocean Inc.
Relative Value Analysis
How does the credit spread to default probability ratio for Transocean Inc. compare to other bonds available in the market place? Is it high, low or average? We answer that question by comparing the credit spread to default probability ratio for Transocean Ltd. with all 235 fixed-rate non-call senior bond issues with a daily trading volume of at least $5 million on July 15 and a maturity of 1 year or more. The first graph shows a histogram of the credit spreads that prevailed on these issues on July 15, 2014:
The median credit spread was 0.872% and the average was 1.147%. The distribution of the reward to risk ratio, the credit spread divided by the matched maturity default probability, is shown in the next histogram. The median ratio is 11.497 and the average ratio is 18.348.
The ratio of credit spread to default probability is shown in this chart for all of the Transocean Inc. bonds with at least $5 million in trading volume. The 4 heavily traded Transocean Ltd. bonds rank from 203rd to 220th when ranked by our value criterion. All of the bonds rank in the bottom 15% of the 235 heavily traded bond issues on July 15.
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 (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 Transocean Ltd. 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 Transocean Ltd. 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 Transocean Ltd. over almost 30 years. We postpone this exercise for another time, but clearly the high credit spreads for Transocean Inc. and (by implication) Transocean Ltd. mean that the credit-adjusted dividend yield will be much lower than the traditional dividend yield.
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 July 11, 2014 (the most recent week for which data is available), the credit default swap trading volume on Transocean Ltd. was 114 trades for $510 million, ranking the firm 123rd among 887 counterparties with at least one trade during the week.
The notional principal traded weekly in the credit default swap market on Transocean Ltd. is shown in this graph of data from the Depository Trust & Clearing Corporation:
The number of credit default swaps traded weekly on Transocean Ltd. is shown in this history graph:
On a cumulative basis, the current default probabilities (in green) for Transocean Ltd. range from 0.35% at 1 year to 9.00% at 10 years. The January 15, 2014 cumulative default probabilities are graphed in orange. Although default risk has dropped in the last six months, the 9.00% 10 year cumulative default risk is among the highest we have seen in this series of notes.
Over the last decade, the 1 year and 5 year annualized default probabilities for Transocean Ltd. spiked in recent years. The 1 year default probability (in blue) peaked at almost 2.00% in 2012. The 5 year default probability (in yellow) recently peaked at more than 1.00%.
The firm’s default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. For an explanation, see the references in each Instablog posted by Kamakura Corporation. Over a long period of time, macro-economic factors drive the financial ratios and equity market inputs as well. If we link macro factors to the fitted default probabilities over time, we can derive the net impact of macro factors on the firm, including both their direct impact through the default probability formula and their indirect impact via changes in financial ratios and equity market inputs. The net impact of macro-economic factors driving the historical movements in the default probabilities of Transocean Ltd. has 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 Transocean Ltd. default risk responds to changes in 11 risk factors among the macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 70.9% of the variation in the default probability of Transocean Ltd. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Transocean Ltd. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the world-wide energy sector, Transocean Ltd. has the following percentile ranking for its default probabilities among its 1,766 peers at these maturities:
1 month 84th percentile
1 year 76th percentile
3 years 72nd percentile
5 years 70th percentile
10 years 70th percentile
Over all time horizons, Transocean Ltd. ranks in the riskiest 30% of its peer group from a credit risk perspective.
Taking still another view, the actual and statistically predicted Transocean Ltd. credit ratings both show a rating in the low end “investment grade” territory. The statistically predicted rating is 1 notch above the legacy rating from firms like the Standard & Poor’s affiliate of McGraw-Hill (MHFI) and Moody’s Investors Service (MCO). The legacy ratings of the company have changed three times in the last decade.
We postpone our conclusions briefly to view some more facts. The “Oil-Gas-Exploration-Energy” peer credit spreads on July 15 are shown here in light blue, with Transocean Inc. credit spreads plotted in dark blue. Transocean Inc. credit spreads are well above the median. We remind readers that the traded bond peer group generally has higher average quality than the full peer group universe.
The matched maturity default probabilities for the “Oil-Gas-Exploration-Energy” peer group with bonds traded on July 15 are shown in this graph:
Transocean Ltd. is among the highest default probabilities of the peer group by this measure. Investment grade credit spreads on all bonds traded on July 15 are shown here in light blue with Transocean Inc. credit spreads plotted in dark blue:
Transocean Inc. falls well above the middle of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus Transocean Ltd.:
Transocean Ltd. is again well above the median of the investment grade peer group.
We believe that the sentiment of sophisticated analysts on investment grade status for Transocean Inc. and Transocean Ltd. is at best a coin flip. The Company’s default risk has fallen over the last six months but it remains in the bottom 30% of the energy peer group. From a “good value” point of view, Transocean Inc. bonds fall in the bottom 15% of the heavily traded bond universe when ranked by the ratio of credit spread to default probability. We strongly discourage small investors from buying these bonds. The primary investor base for Transocean Inc. bonds should be those with very special insights into the off-shore drilling industry and those Wall Street bonus babies for whom personal “success” is so heavily rewarded and for whom personal “failure” is so slightly punished that gambling with one’s employer’s money is good for the employee.
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.