This note focuses on the risk and return on the bonds of Nokia Corporation (NOK), which once dominated the cell-phone world that Apple Inc. (AAPL) now rules. Today's note incorporates Nokia Corporation bond price data as of September 25, 2013. The data is less than we usually analyze in these notes, but in light of Nokia's September 3 agreement with Microsoft Corporation (MSFT) and rumored interest in Alcatel-Lucent (ALU), the analysis is well-worth doing. A total of 90 trades were reported on 2 fixed-rate non-call bond issues of Nokia Corporation with trading volume of $14.7 million. We used all of the data in this study, along with 32 trades on 2 bond issues by Alcatel-Lucent USA Inc. We find a forward-looking risk and return pattern dramatically different from the one we found in our study yesterday of Apple 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 Nokia Corporation 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. The new rules delete references to legacy credit ratings and replace them with default probabilities as explained here.
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 Nokia Corporation.
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 Nokia Corporation 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 default probabilities range from 1.40% at one month to 0.79% at 1 year and 2.78% at ten years. The 10 year default probability is 28 times higher than we found yesterday for Apple Inc. and in an earlier study on Wal-Mart Stores Inc.
We also 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. We used all 4 of the bond issues mentioned above in this analysis, two each for Nokia Corporation and Alcatel-Lucent USA Inc.
The graph below shows 5 different yield "curves" that are relevant to a risk and return analysis of Nokia Corporation bonds. We use the word "curve" loosely since we have only two observable points on the yield curve for both firms. 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 Nokia Corporation 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 line graphs the lowest yield reported by TRACE on that day on Nokia Corporation bonds. The green line displays the average yield reported by TRACE on the same day. The red line is the maximum yield in each Nokia Corporation issue recorded by TRACE.
The graph shows a narrowing "liquidity premium" as maturity lengthens for the bonds of Nokia Corporation. This is a pattern seen usually with firms in at least moderate financial distress. We explore this premium in detail below.
Using dots instead of straight lines, we can plot Nokia Corporation and Alcatel-Lucent USA Inc. bond yields on the same graph. While Nokia Corporation may be in moderate financial distress, the yields on Alcatel-Lucent USA Inc. bonds are even higher by comparison.
The high, low and average credit spreads at each maturity are graphed below for Nokia Corporation. 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 cubic polynomial that explains the average spread as a function of years to maturity. Since we have only two data points, the fit is perfect.
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 credit spread to default probability ratio ranges from 1.6 times at 5.64 years to 1.19 times at 25.64 years. The ratios of spread to default probability for all traded bond issues is shown here:
The credit spread to default probability ratios are shown in graphic form below. Again, we get a perfect fit of a cubic polynomial to the two bonds for which data is available.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended September 20, 2013 (the most recent week for which data is available), the credit default swap trading volume on Nokia Corporation was 62 trades for $331.8 million. This is a much higher volume than in the U.S. bond market, and that differential is often (not always) another sign of financial distress. The number of credit default swap contracts traded on Nokia Corporation in the 155 weeks ended June 28, 2013 is summarized in the following chart. Nokia Corporation is one of the most heavily traded names in the world, with a rank of 64th.
The weekly volume of credit default swaps traded for Nokia Corporation is summarized in this graph:
On a cumulative basis, the default probabilities for Nokia Corporation range from 0.79% at 1 year to 24.53% at 10 years, a high level topped only by Telecom Italia among the firms studied in this series of notes.
Over the last decade, the 1 year and 5 year default probabilities for Nokia Corporation both peaked in mid-2012. The 1 year default probability peaked just short of 9.00%, and the 5 year default probability peaked near 4.50%.
Compared to Alcatel-Lucent, the parent company of Alcatel-Lucent USA Inc., Nokia Corporation is of pristine credit quality. Alcatel-Lucent 1 year default probabilities peaked at more than 70% in 2009 and have been near 10% over the last 12 months.
In contrast to the daily movements in default probabilities graphed above, we turn to the legacy credit ratings for Nokia Corporation, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor's and Moody's (MCO). Over the last decade, the ratings of Nokia Corporation changed six times.
The macro-economic factors driving the historical movements in the default probabilities of Nokia Corporation 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 Nokia Corporation default risk responds to changes in 3 domestic risk factors and 6 international risk factors among the 40 world-wide macro factors used by Kamakura Corporation in its standard risk simulations. These macro factors explain 70% of the variation in the default probability of Nokia Corporation.
Nokia Corporation 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 "information technology-technology and equipment" sector, Nokia Corporation has the following percentile ranking for its default probabilities among its 2,125 peers at these maturities:
1 month 96th percentile
1 year 90th percentile
3 years 90th percentile
5 years 80th percentile
10 years 75th percentile
This is one of the highest collection of percentile ranks of any firm analyzed so far in this series of bond studies. Taking still another view, the actual and statistically predicted Nokia Corporation credit ratings both show a rating strongly in the "non-investment grade" territory. The statistically predicted rating is the same as the legacy rating.
The default probabilities of Nokia Corporation and the percentile ranking of those default probabilities indicate much higher than average credit risk, even after the sale of a large percentage of the firm's business to Microsoft. The credit spreads and ratio of credit spreads to default probabilities are also well below average, at levels so low that taking on Nokia Corporation bond risk is not recommended. Based solely on Nokia Corporation "as is," we believe that almost all analysts would rate Nokia Corporation as "non-investment grade." Is there worse news for Nokia Corporation? Yes. If the rumors of Nokia Corporation's interest in Alcatel Lucent are true, the very big current problems of Nokia Corporation could get an order of magnitude larger. Alcatel-Lucent has a very troubled past and, based on current bond prices, a future that is not much better. Bond holders would be better served by an orderly liquidation of Nokia's assets, rather than having management take on bigger challenges than those they already face.
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.
Additional disclosure: Kamakura Corporatino has business relationships with a number of firms mentioned in this article.