In the last few days, Ford Motor Company (NYSE:F) announced its best revenue year since 2006, boosted its quarterly dividend by 25%, and announced an almost 50% sales increase in one of the world's most important markets, China. In spite of this, Ford's stock price has been flat to down since we last looked at the reward to risk ratio on Ford Motor Company bonds on September 13, 2013. Moreover, default probabilities for Ford Motor Company have risen. This note uses the default probabilities and bond spreads of Ford Motor Company on January 13, 2014, to update the relative reward-to-risk ratio on the firm's bonds.
We conclude that a narrow majority of analysts would rate Ford Motor Company bonds as investment grade and that the reward to risk ratio on Ford bonds has narrowed to below average levels. We explain our conclusions in the remainder of this note.
A total of 160 trades were reported on 15 fixed-rate non-call bond issues of Ford Motor Company with trading volume of $14.9 million. We leave for another day an analysis of spread on the bonds of Ford Motor Credit Co. LLC, whose credit spreads are dramatically lower than Ford Motor Company's spreads.
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 Ford Motor Company. Lastly, we opine on the consensus judgment of whether or not Ford Motor Company bonds are investment grade in light of the revised definition of that term under the Dodd-Frank Act of 2010, which we summarize below.
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 (in green) shows the current default probabilities for Ford Motor Company ranging from one month to 10 years on an annualized basis, compared to their values (in yellow) on September 13, 2013. 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 0.45% at one month (up 0.21% since September) to 0.21% at 1 year (up 0.09% since September) and 1.16% at ten years (up 0.19% since September).
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. We used the bond data mentioned above for the 15 Ford Motor Company fixed rate non-call bond issues mentioned above.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Ford Motor Company 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 Ford Motor Company. 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 (the orange dots) graphs the lowest yield reported by TRACE on that day on Ford Motor Company bonds. The fourth line from the bottom (the green dots) displays the weighted average yield reported by TRACE on the same day. The highest yield recorded by TRACE is denoted by the red dots. The black dots and the black line show the yield derived from using trade-weighted data to fit the credit spread for the company.
The liquidity premium built into the yields of Ford Motor Company above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm) is quite different than we have seen with other issuers. Ford Motor Company bonds currently offer a liquidity premium that narrows as the maturity lengthens and which barely exceeds the sum of the risk free yield and Ford Motor Company's default probability. One can confirm that the 4.75% bonds due January 15, 2043, which cause the credit spread to narrow, are not callable. We explain in more detail below.
The high, low, average, and trade-weighted credit spreads at each maturity are graphed below. The credit spreads peak at about 15 years to maturity and narrow after that. 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 trade-weighted average spread as a function of years to maturity. This polynomial explains 47.5% of the variation in the average credit spread over the maturity term structure.
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 Ford Motor Company The average credit spread to default probability ratio ranges from 1.3 to 2.4 times. This reward to risk ratio indicates below average risk-adjusted returns relative to the other firms analyzed in this series of bond notes, and it is considerably lower than the reward to risk ratio that prevailed on September 13, 2009.
We reproduce the calculated reward to risk ratios for September 13, 2013 in this chart:
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 January 3, 2014 (the most recent week for which data is available), the credit default swap trading volume on Ford Motor Company was 33 trades with $359.5 million of notional principal. This is a substantial trading volume and one that signals a strong diversity of opinion among market participants in the outlook for Ford Motor Company. The number of credit default swap contracts traded on Ford Motor Company in the 155 weeks ended June 28, 2013 is summarized in the following table:
Ford Motor Company ranked 69th among all reference names in weekly credit default swap trading volume during this period, which is graphed below:
On a cumulative basis, the current default probabilities (shown in green) for Ford Motor Company range from 0.21% at 1 year (up 0.09% from September, shown in yellow) to 10.97% at 10 years, up a significant 1.65% since September.
Over the last decade, the 1 year and 5 year default probabilities for Ford Motor Company have been very volatile during the heart of the credit crisis. The one year default probability peaked at more than 50%, and the five 5 year default probability peaked at more than 20%.
The rise in default probabilities since September 13, 2013 is shown in this graph:
Ford Motor Company can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the USA "autos and components" sector, Ford Motor Company has the following percentile ranking for its default probabilities among its 58 peers at these maturities:
1 month 78th percentile, up 16 points since September
1 year 60th percentile, up 8 points since September
3 years 55th percentile, up 13 points since September
5 years 40th percentile, up 3 points since September
10 years 40th percentile, up 5 points since September
The percentile ranking of Ford Motor Company default probabilities at one month through one year is in the riskiest half of the peer group. The percentile ranking for Ford Motor Company at 3 through 10 years is in the second safest quartile of the peer group. Taking still another view, both the actual and statistically predicted Ford Motor Company credit ratings are barely "investment grade" by traditional credit rating standards of Moody's Investors Service and the Standard & Poor's affiliate of McGraw-Hill. The statistically predicted rating is one notch higher than the legacy rating. Over the last decade, legacy ratings have changed 11 times compared to the daily changes in the default probabilities shown above.
Before reaching any conclusions about whether or not Ford Motor Company would be judged investment grade or not by most analysts, we let the market speak for itself. Credit spreads for firms in the "autos-auto parts" sector whose bonds traded on January 13, 2014 are plotted in the light blue dots, while average credit spreads on the Ford Motor Company bonds are plotted in the dark blue. Ford Motor Company credit spreads are near the median, and there is clearly a greater ability at Ford to issue long maturity bonds than there is in the peer group as a whole.
Among the sector peer group whose bonds traded on January 13, 2014, default probabilities for Ford Motor Company were at the top of the peer group.
Credit spreads on the peer group that has investment grade legacy ratings are plotted in the next graph, with the credit spreads for Ford Motor Company overlaid in dark blue. Ford Motor Company credit spreads seem slightly above the median.
The investment grade peer group's matched maturity default probabilities are plotted in the light blue in this graph. The matched maturity default probabilities for Ford Motor Company are at the high end of this group.
We believe that a small majority of analysts would rate Ford Motor Company as investment grade. In spite of the "upgrade" of a Ford legacy rating in September, the market is moving against Ford: the stock price is flat to down, default probabilities are up, and credit default swap trading volume is up.
From a bond risk and return point of view, Ford Motor Company bonds offer a ratio of credit spread to default risk that is below average. Like AT&T (NYSE:T), featured in another Kamakura research report, we continue to speculate that the iconic nature of the Ford brand name has led investors to overprice the bonds of Ford.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firm 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 firm 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 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."
Additional disclosure: Kammakura Corporation has business relationships with a number of firms mentioned in the article.