As we have noted in prior municipal bond analyses, the credit default swap market is often quoted as the source of credit risk information. In this note, we again turn to the municipal bond market and actual traded prices to analyze the market view of the credit risk of the State of California. A recent analysis by Kamakura Corporation showed that only 10 municipal or sub-sovereign entities had any credit default swap trades in the 155 weeks ended June 28, 2013. The State of California, which was one of the 10 municipals, averaged only 1.97 trades per day in the credit default swap market. On average, only 25% of credit default swap trades have at least one non-dealer as a party to the trade, so only 0.49 trades per day in the State of California credit default swaps are trades that involve an ultimate investor. The most recent week in which the Depository Trust & Clearing Corporation reported trades in the State of California credit default swaps was the week ending December 20, 2013. During that week, there were only 2 trades for a notional principal amount of $6 million in the State of California.
In this note, we analyze all of the trades from July 1 through December 24 on just one general obligation bond issued by the State of California. The 5% bonds due February 1, 2038, were the largest tranche of the bonds issued March 8, 2012, by the State of California. The remaining maturity on the bonds is just over 24 years.
The original issue documentation and current financial information is available from the EMMA website of the Municipal Securities Rulemaking Board ("MSRB"). The bonds are not guaranteed by a third party. The source of repayment of the bonds is described on page 2 of the offering documentation:
This particular issue of bonds is subject to early redemption as described on page 10 of the offering documentation:
Given that early redemption can take place as early as February 1, 2022, the bond's maturity could be anywhere from 8 years to 24 years. In what follows, we make the naïve assumption that the bonds remain outstanding until maturity. In subsequent bonds, we make the complex adjustments for the prepayment option on the bonds.
State of California Municipal Bond Issue Yields and Credit Spreads
The MSRB website EMMA includes recent trading activity on a vast array of municipal bond issues in the United States. We use that data to derive the credit spreads of the 5.00% bonds due February 1, 2038, issued by the State of California. From July 1 through December 24, in that one bond issue alone, there were 978 trades for a total principal value of $356 million. This is more than double the total principal amount of these bonds issued, $159.2 million. The average trading volume per day on which trades occurred during this period was $3.2 million, with a daily high of $36.1 million and a low of $5,000. The average number of trades, on the 110 days on which trading took place, was 8.89 trades per day. The total trading volume on all bonds issued by the State dwarfs the volume in the credit default swap market.
On each day for which a trade was reported, the yields to maturity for each trade were collected from the MSRB website. The remaining maturity of the bonds was calculated and the matched maturity U.S. Treasury yield was calculated using Treasury rate information from Kamakura Risk Information Services and the U.S. Department of the Treasury. The credit spread was calculated simply as the bond yields minus the matched maturity U.S. Treasury yields. We adjust this spread for the early redemption option in later blogs. We turn now to those results.
State of California 5% Bonds due February 1, 2038
The evolution of yields to maturity and matched maturity Treasury yields on the 5.00% general obligation bonds due February 1, 2038, are shown in this graph:
The difference versus U.S. Treasuries has shown a roller coaster pattern over the course of 2013. All trades during this period are reflected on this graph with no omissions or smoothing. For the readers' convenience, we have added a smooth line to the reported yields on the 5.00% bonds due February 1, 2038. The credit spreads themselves are shown in the next graph:
In subsequent blogs, we will also display trade-weighted credit spreads and credit spreads for large volume trades.
Spreads on December 24 ranged between 0.64% and 0.90% over matched-maturity U.S. Treasuries.
Credit Default Swap Trading Volume in the State of California
For comparison purposes, the weekly number of trades in the State of California in the credit default swap market as reported by the Depository Trust & Clearing Corporation is reported here for the 155 weeks ending June 28, 2013:
The weekly trading volume in credit default swaps on the State of California is summarized in this table:
The State of California ranked 702nd in trading volume among all reference names during this period.
The credit spreads shown above for the State of California 5.00% bonds reflect the default risk, related recovery risk, and early redemption risk associated the State of California's general obligations. It is clear that the State of California has not been affected in a significant way by the bankruptcy of Detroit and the much-discussed problems of the State of Illinois and the Commonwealth of Puerto Rico. In subsequent blogs, we will add trade weighting, the current term structure of credit spreads, default probabilities (see below), an assessment of current "investment grade" status (see below), and early redemption adjustment to the analysis.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the organization in question. We believe that other authors on Seeking Alpha, 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 organization 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.
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.
Background on the Dodd-Frank Act and the Meaning of "Investment Grade"
Section 939A of the Dodd-Frank Act states the following:
"SEC. 939A. REVIEW OF RELIANCE ON RATINGS.
(A) AGENCY REVIEW.-Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review-
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(B) MODIFICATIONS REQUIRED.-Each such agency shall modify any such regulations identified by the review conducted under subsection to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(C) REPORT.-Upon conclusion of the review required under subsection, each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to the subsection.
The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:
"In this rulemaking, the OCC has amended the regulatory definition of 'investment grade' in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is 'investment grade,' banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution's risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised 'investment grade' standard."