Royal Dutch Shell PLC: The View from the Bond Market

Conclusion: We find that Shell International Finance B.V. bonds offer investors a rare combination: both low default risk and an above average reward-to-risk ratio as measured by the ratio of credit spread to matched-maturity default probability.

Shell International Finance B.V. Bond Analysis

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 Shell International Finance B.V. to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010.  The default probabilities used are described in detail in the daily default probability analysis posted by Kamakura Corporation. The full text of the Dodd-Frank legislation as it concerns the definition of “investment grade” is summarized at the end of our analysis of Citigroup (C) bonds published December 9, 2013.  Because of the parent guarantee, we make the slightly optimistic assumption that the default probabilities of Shell International Finance B.V. are identical to those of the parent, Royal Dutch Shell PLC. This assumption is a good first approximation.

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 Shell International Finance B.V.

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 Royal Dutch Shell PLC 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 current default probabilities range from 0.01% at one month to 0.01% at 1 year and 0.05% at ten years, half of the long-term default risk that we found last week in our analysis of Wal-Mart Stores Inc.

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 17 Shell International Finance B.V. fixed rate non-call senior bond issues mentioned above.

The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Shell International Finance B.V. 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 Shell International Finance B.V. 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 dots graph the lowest yield reported by TRACE on that day on Shell International Finance B.V. bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day.  The red dots represent the maximum yield in each Shell International Finance B.V. issue recorded by TRACE. The black dots and connecting line are derived from fitting a trade-weighted cubic polynomial to Shell International Finance B.V. credit spreads.

The graph shows a generally increasing “liquidity premium” for holding the bonds of Shell International Finance B.V. except at the longest end of the curve. 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 trade-weighted cubic polynomial that explains the average spread as a function of years to maturity.  This polynomial explains 95.30% of the variation in the average credit spread over the credit spread 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 average credit spread to default probability ratio is generally more than 10 for maturities less than 4 years. For maturities beyond that, the ratio is generally between 10 and 21, a higher than average high ratio for a credit of this quality. These ratios of spreads to default probabilities are shown in the following table for Shell International Finance B.V.:

The credit spread to default probability ratios are shown in graphic form here:

What evidence do we have that the reward to risk ratio on Shell International Finance B.V. is “above average”?  The evidence is shown in this graph:

The graph plots the distribution of the credit spread to default ratios for all senior non-call fixed rate corporate bonds traded in the United States market on January 29, 2014 with a daily trade volume of more than $5 million and a maturity of more than one year. There were 374 trades which met these criteria, of which 353 trades were “investment grade” by the legacy rating agency definition. Only 1 percent of the trades had a reward to risk ratio below 1.29.  5 percent of the trades had a ratio of 2.55 or less.  25 percent of the trades had a reward to risk ratio of 5.62 or less.  The median reward to risk ratio was 11.28.  25 percent of total trades had a reward to risk ratio greater than 19.88.  All of the Shell International Finance B.V. bonds with maturities greater than 6 years exceeded the 11.28 median 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 January 24, 2014 (the most recent week for which data is available), the credit default swap trading volume on Royal Dutch Shell PLC was 45 trades for $88.7 million of notional principal.  The daily “non-dealer” number of credit default swap contracts traded on Shell International Finance B.V. in the 181 weeks ended December 27, 2013 averaged 0.76 contracts per day.  The daily average non-dealer volume of credit default swaps on Royal Dutch Shell PLC was $4.2 million, less a tenth of the bond market volume reported on January 29, 2014.  Note that 72.48% of trading in the credit default swap market is between dealers according to a January 10, 2014 report by the Depository Trust & Clearing Corporation. For an analysis of credit default swap trading volume over the period 2010 to 2013, please see this recent report from Kamakura Corporation.

The weekly number of contracts traded in the 181 weeks ended December 27, 2013 is shown here for Royal Dutch Shell PLC.

The weekly notional principal of credit default swaps traded on Royal Dutch Shell PLC in the 181 weeks ended December 27, 2013 is shown here:

On a cumulative basis, the current default probabilities for Royal Dutch Shell PLC range from 0.01% at 1 year to 0.51% at 10 years, compared to 1.04% for Wal-Mart Stores Inc. in our report of last week.

Over the last decade, the 1 year (in blue) and 5 year default probabilities (in yellow) for Royal Dutch Shell PLC have never exceeded 0.09% at any time, even during the heart of the 2006-2011 credit crisis. Note, however, that the five year default probabilities have been rising for some time.

In contrast to the daily movements in default probabilities graphed above, we turn to the legacy credit ratings for Royal Dutch Shell PLC, 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, compared to 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 Royal Dutch Shell PLC 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 Royal Dutch Shell PLC default risk responds to changes in six risk factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. The most important factor, not surprisingly, is oil prices. These macro factors explain 86.5% of the variation in the default probability of Royal Dutch Shell PLC.

Royal Dutch Shell PLC 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, Royal Dutch Shell PLC has the following percentile ranking for its default probabilities among its 255 peers at these maturities:

1 month	31st percentile
1 year	29th percentile
3 years	30th percentile
5 years	15th percentile
10 years	11th percentile

The percentile ranking of Royal Dutch Shell PLC default probabilities is higher than one might expect in the short run simply because all firms in this sector are benefitting enormously from credit conditions that Kamakura Corporation currently ranks at the 96th percentile (with 100 representing the best credit conditions since 1990). Taking still another view, the actual and statistically predicted Shell International Finance B.V. credit ratings both show a rating strongly in “investment grade” territory.  The statistically predicted rating is three notches below the legacy rating, however.

Conclusions

Before reaching any conclusions about the “investment grade” status of Shell International Finance B.V. bonds, we first look at more data from the bond market.  We exclusively use data from January 29, 2014.  We first look at a comparison of credit spreads on traded Shell International Finance B.V. bonds versus traded bonds in the same “energy” sector:

Shell International Finance B.V. trades well below the median of the peer group, although the number of bonds traded for the peer group is relatively small.  We next look at the comparison of matched-maturity default probabilities for Royal Dutch Shell PLC/Shell International Finance B.V. versus the same peer group for bonds traded January 29:

The default probabilities are near the lowest (safest) range of the peer group.  We now turn to the larger data set of traded bonds among firms with a legacy rating consistent with the older definition of “investment grade.”  This graph shows that Shell International Finance B.V. is trading at the bottom range (i.e. the best levels) of investment grade firms:

Matched-maturity default probabilities are also very low compared to the matched-maturity default probabilities on investment grade bonds traded January 29:

We believe that an overwhelming majority of analysts would rate Shell International Finance B.V. as investment grade.  That is true even though we believe that the legacy ratings of the firm represent a three notch “over-rating,” due largely to the stickiness of ratings for iconic names with a stellar legacy ratings history.

Shell International Finance B.V. offers considerable value to bond investors, more so than almost all of its peers, for two reasons.  First, its long term default probabilities are among the lowest in the energy sector.  Second, the reward to bond holders per basis point of default risk is well above average for all bonds with maturities of six years or more.

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. For the same reason, we do not discuss political issues facing bond issuers, particularly in the sovereign and municipal bond arena. We leave that to the political pundits who spend their life on those issues.