In this note we analyze the current levels and past history of default probabilities for Hewlett-Packard Company (NYSE:HPQ). We compare those default probabilities to credit spreads on 311 bond trades on July 15, 2013. 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. We analyze the maturities where the credit spread/default probability ratio is highest for Hewlett-Packard Company. We also 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.
Definition of Investment Grade
On June 13, 2012, the Office of the Comptroller of the Currency published the final rules defining whether a security is "investment grade," in accordance with Section 939A of the Dodd-Frank Act of 2010. The new rules delete reference to legacy credit ratings and replace them with default probabilities. The web page explaining the Office of the Comptroller of the Currency's new rules defining investment grade and related guidance can be found here.
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 Hewlett-Packard Company ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.40% at one month to 0.21% at 1 year and 0.45% 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 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. TRACE data for Hewlett-Packard Company was extensive on July 15, 2013. 311 trades were reported on 16 different bond issues. The high, low and average credit spread at each maturity are graphed here:
Because we have 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 this table for Hewlett-Packard Company.
The next graph plots the ratio of credit spread to default probability at each maturity.
For Hewlett-Packard Company, the highest spread/default probability ratios are found in the 2 year to 3.5 year maturity range, with average spread/default probability ratios of more than 5. For other maturities, the spread/default probability ratio hovers around 4, and then rises above 5 again at the 28 year maturity.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended July 5, 2013 (the most recent week for which data is available), the credit default swap trading volume on Hewlett-Packard Company showed 20 contracts trading with a notional principal of $72.2 million.
On a cumulative basis, the default probabilities for Hewlett-Packard Company range from 0.21% at 1 year to 4.42% at 10 years.
Over the last 10 years, the 1 year and 5 year default probabilities for Hewlett-Packard Company have varied as shown in the following graph. The one year default probability peaked at slightly over 1.80% in the last year after spending most of the decade well below 0.40%.
Over the same decade, the legacy credit ratings for Hewlett-Packard Company have changed only twice.
The macro-economic factors driving the historical movements in the default probabilities of Hewlett-Packard Company over the period from 1990 to the present include the following factors of those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
- Growth in real gross domestic product
- Growth in nominal gross domestic product
- U.S. Treasury 3 month bill rate
- U.S. Treasury 10 year bond yield
- Level of the Dow Jones industrials stock index
- 3 international macro factors
These macro factors explain 80.6% of the variation in the default probability of Hewlett-Packard Company since 1990.
Hewlett-Packard Company can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the US Information Technology sector, Hewlett-Packard Company has the following percentile ranking for its default probabilities among its peers at these maturities:
1 month 83rd percentile
1 year 69th percentile
3 years 54th percentile
5 years 29th percentile
10 years 20th percentile
A comparison of the legacy credit rating for Hewlett-Packard Company with predicted ratings indicates that the company is overrated by one ratings grade.
Hewlett-Packard Company has experienced considerable volatility in its default probabilities in recent years. At current default probability levels, Hewlett-Packard is in the riskier half of its peers for maturities ranging from 1 month to 3 years. At maturities of 5 and 10 years, however, the company ranks in the safest one-third of its peer group. While a prudent investor should monitor this credit closely, we believe that most sophisticated analysts would rate Hewlett-Packard Company 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.