In this note we analyze the current levels and past history of default probabilities for Yahoo Inc. (YHOO). As part of this analysis, we consider whether or not a reasonable investor would judge the firm to be "investment grade" under the June 2012 rules mandated by the Dodd-Frank Act of 2010. The Office of the Comptroller of the Currency has issued new rules defining investment grade and related guidance; documentation can be found here. Given a level of risk appetite, a sophisticated fixed income investor seeks to maximize revenue per basis point of default risk, and this note is intended as an aid to that effort.
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. This graph shows the current default probabilities for Yahoo Inc. ranging from one month to 10 years on an annualized basis.
Using the best performing model (Jarrow-Chava version 5) from Kamakura Risk Information Services, Yahoo Inc. has annualized default probabilities of 0.03% at 1 year and 0.33% at ten years. 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 bond 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. TRACE data for Yahoo Inc. shows that there were no transactions in Yahoo fixed income securities on July 9, 2013. Data from the Depository Trust & Clearing Corporation confirms that there were also no trades in credit default swaps on Yahoo Inc. in the week ended July 5, 2013.
Cumulative Default Probabilities
On a cumulative basis, the default probabilities for Yahoo Inc. range from 0.03% at 1 year to 3.21% at 10 years.
Over the last 10 years, the 1 year and 5 year default probabilities for Yahoo Inc. have varied as shown in the following graph. At no point did the default probabilities exceed 0.70%.
Over the same period, management of Yahoo Inc. did not feel that legacy credit ratings added shareholder value, so there are no credit ratings on Yahoo Inc.
The macro-economic factors driving the historical movements in the default probabilities of Yahoo Inc. over the period from 1990 to the present include the following factors included by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
- Real growth in gross domestic product
- Change in the consumer price index
- Changes in the Dow Jones stock index
- Changes in the Fed's commercial real estate price index
- Five international macro-economic factors
These factors explain 56.3% of the movements in the 1 year default probability of Yahoo Inc., a much lower than normal exposure to systematic risk factors. Yahoo Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the USA software and services sector, Yahoo Inc. has the following percentile ranking for its default probabilities among its peers at these maturities:
1 month 65th percentile
1 year 36th percentile
3 years 14th percentile
5 years 16th percentile
10 years 15th percentile
The long run risk of Yahoo Inc. is well below peer group levels. Yahoo Inc. has no legacy credit rating. Using a data base of 263,000 observations of legacy ratings, Kamakura Risk Information Services predicts a credit rating of BBB for Yahoo Inc.
While Yahoo Inc. has higher than average short term default risk compared to its peer group, its long run risk is well below long run peer group averages. We believe that most serious analysts would rate Yahoo Inc. as investment grade by the Comptroller of the Currency definition.
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.