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In a recent note we compared the market's view of the capital strength of Bank of America Corporation (BAC), Citigroup Inc. (C), and JPMorgan Chase & Co. (JPM). In today's note, we expand the analysis to a ranking of all financial institutions which had U.S. market daily trading volume of $5,000,000 or more in 1 or more bonds with a maturity of more than one year. We reach some surprising conclusions much more quickly and much more cheaply than using the bank stress-testing procedures implemented by bank regulators around the world.

Conclusion: Using 2,088 trades on 129 bonds with a principal amount of $1,535,206,000 on February 5, the major financial institutions trading with the narrowest credit spreads are Bank of America N.A. , National Australia Bank Ltd. (New York Branch) (OTCPK:NABZY)(OTC:NAUBF), General Electric Capital Corporation (GE), Bank of Montreal (BMO), and Wells Fargo & Co. (WFC). We analyze the same institutions for "best value" and lowest default probabilities in what follows.

The Market Risk Ranking

The 30 largest U.S. bank holding companies have submitted their Comprehensive Capital Analysis and Review 2014 stress tests to the Federal Reserve in recent weeks. The major banks in the United States are spending tens of millions of dollars to analyze the banks' ability to avoid default over 13 quarters and three scenarios for 28 macro-economic factors specified by the Federal Reserve. There is an alternative way to compare the capital strength of major financial institutions that avoids the well-known problems of legacy credit ratings and the highly concentrated trading in credit default swaps, 72.48% of which is among dealers and 87% of which is concentrated at a five year maturity. A superior alternative is to use traded bond prices of the major financial institutions in order to extract a market view of the capital adequacy of the banks.

This analysis uses 2,088 trades in 129 non-call fixed rate bonds with a principal amount of $1,535,206,000 for 22 major financial institutions around the world. All trades took place on February 5, 2014. This analysis differs from the CCAR 2014 stress testing process in a number of important dimensions:

  1. The market risk assessment is based on investments of $1.56 billion by institutional investors. The bankers doing the CCAR 2014 analysis have somewhat less at stake.
  2. The market risk assessment is predominately an arms-length assessment, while the banks' CCAR 2014 analysis is a self-assessment with the same potential concerns associated with the self-assessment published annually by legacy rating agencies.
  3. The market risk assessment is based on all possible scenarios, not just the 3 CCAR 2014 scenarios
  4. The market risk assessment includes maturities out to 2044 (the maturity of the longest maturity bond traded was February 1, 2044), while the CCAR analysis is available for 13 quarters.
  5. The market risk assessment is completely transparent, as the traded bond prices are public information
  6. The market risk assessment is "model independent," as no explicity default probability models or parameter assumptions are made as part of the analysis.

The financial institutions whose bond trades were included are listed here:

AMERICAN EXPRESS CO

AMERICAN EXPRESS CREDIT CORP

AMERIPRISE FINANCIAL INC

APOLLO INVESTMENT CORP

BANK OF AMERICA CORP

BANK OF AMERICA NA

BANK OF MONTREAL

BANK OF NOVA SCOTIA

CAPITAL ONE FINANCIAL CORP

CIT GROUP INC

CITIGROUP INC

COMERICA INC

FIRST HORIZON NATIONAL CORP

GENERAL ELECTRIC CAPITAL CORP

GOLDMAN SACHS GROUP INC

JPMORGAN CHASE & CO

LEGG MASON INC

MORGAN STANLEY

NATIONAL AUSTRALIA BANK LTD ( NEW YORK BRANCH)

ROYAL BANK OF CANADA

TORONTO DOMINION BANK

WELLS FARGO & CO

Calculation of Credit Spreads

The underlying U.S. Treasury yields used to calculate credit spreads are taken from the Federal Reserve H15 statistical release and interpolated by Kamakura Corporation to match the exact maturity date of each bond. This matched maturity U.S. Treasury yield is subtracted from the high, low and trade-weighted average yield for each bond on February 5, 2014.

We now turn to the market risk assessment of the 22 financial institutions.

Ranking by Credit Spreads

We first rank the institutions by credit spread, where lowest credit spread is judged "best." Because most of the financial institutions have more than one traded bond, we take the "best bond" for each institution to do the ranking. The distribution of the credit spreads among the 129 traded bonds is given in this histogram:

(click to enlarge)

The lowest credit spread of all of the trades was 0.0025%. The highest credit spread was 2.27%, and the median credit spread was 0.81%. The ten institutions with the lowest credit spreads ranked as follows:

  1. Bank of America N.A.
  2. National Australia Bank Ltd. (New York Branch)
  3. General Electric Capital Corporation
  4. Bank of Montreal
  5. Wells Fargo & Co.
  6. American Express Credit Corp.
  7. Royal Bank of Canada
  8. Comerica Inc.
  9. Bank of Nova Scotia
  10. JPMorgan Chase & Co.

The 50 bond trades with the lowest credit spreads are shown here:

(click to enlarge)

Ranking by Best Value as a Bond Investment

Using credit spread alone as an investment tool is not sufficient to determine whether or not a bond is "good value." In this series of notes, we have argued that the ratio of credit spread to matched maturity default probability is a powerful indicator of relative value. We use matched maturity default probabilities from Kamakura Risk Information Services in this analysis. Over all 129 bonds traded, the spread to default probability ratios were distributed as follows:

(click to enlarge)

The minimum spread to default probability ratio (i.e., the worst) was 0.027. The median ratio was 17.00, and the maximum was 91.19.

The ten institutions that provide "best value" are listed here:

  1. Goldman Sachs Group Inc.
  2. American Express Credit Corp.
  3. CIT Group Inc.
  4. National Australia Bank Ltd. (New York Branch)
  5. Capital One Financial Corp.
  6. Bank of Nova Scotia
  7. Toronto Dominion Bank
  8. JPMorgan Chase & Co.
  9. Royal Bank of Canada
  10. Ameriprise Financial Inc.

The top 50 bonds ranked from the best spread to default probability ratio to the worst ratio are shown here:

(click to enlarge)

Ranking by Default Probabilities

Another investment criterion is simply to buy bonds with the lowest absolute level of default probabilities. Ranking the 129 bond trades in order from lowest default probability to the highest default probability provides an "investment menu" by this criterion. We show the lowest default probabilities on 50 of the 129 bond trades on February 5 of at least $5 million or more and maturities of more than 1 year in the "Banks/Finance" sector in this chart. The bonds are ranked from the lowest default probability (in percent) to the highest:

(click to enlarge)

Key conclusions

Regulatory stress testing is an important tool for both bank regulators and investors in assessing the risk of major financial institutions. Secondary market bond prices and default probabilities are at least as important and provide much more detailed insights than regulatory stress tests for the reasons outlined above. Sophisticated regulators and investors should be using all of these tools for an accurate assessment of bank capital adequacy and counterparty credit risk.

Author's Note

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 SeekingAlpha, 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.

Source: Capital Strength: A Market Risk Ranking Of Major Financial Institutions

Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.