In this update of our October 23, 2013 analysis, we track the impact on Dell Inc. bond holders of the close of the merger agreement with Michael Dell and Silver Lake Partners. In this note we re-analyze the credit spreads for Dell Inc. (DELL). We look at data for 262 bond trades in 8 different Dell Inc. bond issues with principal value of $88.2 million on November 26, 2013. In our October 23 post, we declined to forecast the behavior of one individual, Michael Dell, in favor of waiting to see what he does. Our analysis shows that bond holders of Dell Inc. have lost a substantial amount of value as Dell and his partners intentionally raised the probability of bankruptcy and the volatility of returns to equity holders (themselves) by aggressively leveraging the firm in an industry where leverage is rare for a reason.
This drop in long-maturity bond value came about after the buyout of Dell Inc. closed on October 29, financed in part by a loan of $7.2 billion. The firm’s legacy ratings were downgraded to junk by three legacy rating agencies on February 5, September 11, and October 30. This blog shows that the greatest losses since trading on October 21 have come at maturities of 15 years and longer.
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. For details on how Dodd-Frank has changed the definition of “investment grade,” please see the note at the end of this article.
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
Now that Dell Inc. is a private company, its public firm default probabilities are no longer available since stock prices are a key input into that calculation. Dell Inc.’s non-public firm default probabilities are available, but they depend on a forecast for the balance sheet of the firm. We do not report them in this note, focusing instead on traded bond prices and the resulting credit spreads.
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 a number of 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. This curve is shown for October 21 but not for November 26 because public firm default probabilities for Dell Inc. are no longer available. 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). Credit spreads in aggregate have widened on the long end of the curve by a considerable amount since October 21. We first display spreads as of November 26.
The next graph is the same view of Dell Inc. bonds on October 21, 2013. It is clear to even the most casual observer that the credit spreads of Dell Inc. widened very significantly between October 21 and November 26 at the longer maturities.
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 generally 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. Spreads peak at nearly 6% for the 15 year maturity for Dell Inc., an extremely high level.
At the 15 year maturity point, Dell Inc. credit spreads have widened to nearly 6.00%, compared to credit spreads of less than 5.00% at the same maturity on October 21, as shown in this graph.
The Dell Inc. 2.30% bonds due 9/12/2015 had a weighted average credit spread of 1.66% on November 26, 0.10% less than reported on October 21, 2013 by TRACE. The 3.10% bonds due April 3, 2016 had an average November 26 credit spread of 2.21%, 0.09% less than the spread on October 21. At longer maturities, however, credit spreads have blown out dramatically. The 7.10% bonds due April 17, 2028 now have a credit spread of 5.91%, up 0.99% from October 21. The 6.50% bonds due April 17, 2038 have a weighted average credit spread of 5.42%, up from 4.78% on October 21, 2013. The first table shows spreads as of November 26. The 7.10% bonds and 6.50% bonds were the two most heavily traded Dell bond issues on November 26.
The credit spreads and their relationship to default probabilities for October 21, 2013 are shown in the chart below:
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. Trading volume in the credit default swaps of Dell Inc. has dramatically increased over the last month. During the week ended November 22 (the most recent week for which data is available), there were 121 trades for $477 million, which ranks Dell 72nd by contracts traded. This compares with only 26 contracts and a volume of $124 million for the week ended October 11. 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:
Last week’s trading volume of 121 contracts exceeds almost all weekly trading volumes except for those weeks around the signing of the LBO plans on February 5, 2013.
Before reaching any conclusions about the credit risk of Dell Inc. in light of the facts, above, it is helpful to take a broader “relative value” market view. The graph below plots the credit spreads of Dell Inc. among its peers in the “TMT” (technology, media and telecommunications) industry sector. Dell Inc. now ranks at the very high end of the TMT peer group across the full spectrum of maturities outstanding.
We can make a similar comparison with the credit spreads of firms with a traditional “investment grade” credit rating from the legacy credit rating agencies. Again, Dell Inc. is now “off the charts” on the wrong end of the credit spectrum.
In our analysis of October 21, we noted that Dell Inc. credit spreads at the time reflected 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. Since then, investors have clearly abandoned ship from the longer Dell bond maturities while spreads have tightened a bit on the shorter end of the maturity spectrum. Analysts clearly are pessimistic that this leveraged buyout will have any virtues to offset the usual LBO “rob the bond holders so the new owners can go double or nothing” scenario. At current credit spread levels, the market has spoken and all credit risk assessment techniques are giving similar answers. Dell Inc. has leveraged itself in an industry than can’t tolerate leverage and its investment grade ranking is the price paid. Clearly, in the last month, there has been a sea-change in credit spreads and pessimism, and we believe an overwhelming majority of sophisticated analysts would put Dell Inc. in the non-investment grade category.
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 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.”
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.