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, "investment grade" is an internal definition; for many banks and insurance companies, "investment grade" is also defined by regulators. In this note we analyze the current levels and past history of default probabilities for BP PLC (BP). BP PLC has issued in the U.S. market through guaranteed subsidiary BP Capital Markets PLC, with one issue via BP Capital Markets America Inc. We compare BP PLC default probabilities to credit spreads on U.S. dollar bonds traded in the U.S. market. On August 6, BP PLC affiliate bonds had 122 trades for $68.1 million. In this note, after eliminating outliers, we use data on 118 of those trades.
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 BP PLC. We also consider whether or not a reasonable U.S. bank 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 as explained 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 BP PLC ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.12% at one month to 0.05% at 1 year and 0.14% 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 BP PLC included 122 trades in 21 fixed-rate non-callable bonds of the firm on August 6, 2013. We used 118 trades in this note.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of BP PLC 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 BP PLC. 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. The third line from the bottom (in orange) graphs the lowest yield reported by TRACE on that day on BP PLC bonds. The fourth line from the bottom (in green) displays the average yield reported by TRACE on the same day. The highest yield is obviously the maximum yield in each BP PLC issue recorded by TRACE.
The data makes it very clear that there is a stable liquidity premium built into the yields of BP PLC above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm). The credit spreads are relatively smooth across the maturity spectrum.
The high, low and average credit spreads at each maturity are graphed below. Credit spreads are gradually increasing with the maturity of the bonds, although the TRACE data shows that credit spreads can vary considerably during the day.
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. This ratio of spread to default probability is shown in the following table for BP PLC. At all maturities, the reward from holding the bonds of BP PLC, relative to the matched maturity default probability, is at least 3 basis points of credit spread reward for every basis point of default risk incurred. The ratio of spread to default probability increases with maturity to more than 8 basis points of credit spread per basis point of default risk at the longest maturities.
The credit spread to default probability ratios are shown in graphic form here:
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended August 2, 2013 (the most recent week for which data is available), the credit default swap trading volume on BP PLC showed 18 contracts trading with a notional principal of $117.4 million for the entire week. The next graph shows the weekly number of credit default swaps traded on BP PLC in the 155 weeks ended June 28, 2013. BP PLC ranked 214th of 1,144 reference names in contracts traded over this period:
The table below summarizes the key statistics of credit default swap trading in BP PLC during this three year period.
On a cumulative basis, the default probabilities for BP PLC range from 0.05% at 1 year to 1.44% at 10 years, as shown in the following graph.
Over the last decade, the 1 year and 5 year default probabilities for BP PLC have varied as shown in the following graph. The one year default probability peaked at just under 0.40% and the 5 year default probability peaked at just under 0.25% during that period, both peaking at the heart of the Gulf of Mexico oil spill. This is an exceptional performance relative to other firms which were failed or rescued during the credit crisis.
The macro-economic factors driving the historical movements in the default probabilities of BP PLC include the following factors of those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
- The Dow Jones Industrial index
- 10 year U.S. Treasury yield
- Home price indices
- Commercial real estate price indices
- 5 eurozone macro factors and 2 other international macro factors
These macro factors explain 54.6% of the variation in the default probability of BP PLC, a very low proportion given the idiosyncratic risk of the Gulf Oil spill and its impact on BP PLC default probability history.
BP PLC can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the worldwide energy sector, BP PLC has the following percentile ranking for its default probabilities among its peers at these maturities:
1 month 65th percentile
1 year 42nd percentile
3 years 25th percentile
5 years 19th percentile
10 years 15th percentile
BP PLC is in the riskier half of energy sector firms for maturities of one year or less, but it moves into the lower quartile of risk for maturities of 3 years and longer. A comparison of the legacy credit rating for BP PLC with predicted ratings indicates that the statistically predicted rating is 1 ratings notch below the actual legacy rating assigned to the company.
BP PLC is in the lower quartile of default risk among worldwide energy sector peer group companies for maturities of 3 years or more. BP PLC ranks in the riskier half of the peer group for maturities of one year or less, probably because of the residual compensation risk from the Gulf of Mexico oil spill, with ultimate liability still being played out in U.S. courts. BP PLC default probabilities showed impressive stability through the Gulf oil crisis because of the strong market value of its reserves. Ironically, this very stability in times of crisis has led investors to bid up the price of BP PLC bonds to the point where the number of basis points of credit spread to default probabilities is lower than many firms analyzed so far in this series of notes. We believe the vast majority of analysts would rate BP PLC as investment grade.
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.