On February 7, 2014, the bonds of International Business Machines Corporation (IBM) were the second most heavily traded of any reference name in the U.S. fixed rate corporate bond market. Today's note incorporates International Business Machines Corporation bond price data to rank IBM by both credit worthiness and relative value compared to other firms whose bonds traded that day. A total of 135 trades were reported on 21 fixed-rate non-call senior bond issues of International Business Machines Corporation with trading volume of $252.4 million. We used all of that data in this note.
Conclusion: In spite of recent financial performance, the default probabilities for International Business Machines Corporation are the lowest in its peer group for time horizons of 5 years or more. The company's bonds offer a reward to risk ratio that is slightly better than the median for all fixed rate corporate bonds which traded at least $5 million in volume on February 7. While "slightly better than the median" may not excite some readers, this is a far better credit spread to default probability ratio than we have seen on other iconic brand names in this series of notes.
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 International Business Machines Corporation to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. The default probabilities used are described in detail in the daily default probability analysis posted by Kamakura Corporation. The full text of the Dodd-Frank legislation as it concerns the definition of "investment grade" is summarized at the end of our analysis of Citigroup (C) bonds published December 9, 2013.
Assuming the recovery rate in the event of default would be the same on all bond issues of the same issuer, 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 International Business Machines 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 International Business Machines 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 0.00% at one month (0.001902% before rounding) to 0.00% at 1 year (0.00353% before rounding) and 0.08% at ten years.
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 the 21 bond issues mentioned above in this analysis.
The graph below shows 6 different yield "curves" that are relevant to a risk and return analysis of International Business Machines Corporation 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 (TLT)(TBT), interpolated from the Federal Reserve H15 statistical release for that day, which exactly matches the maturity of the traded bonds of International Business Machines 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 dots graph the lowest yields reported by TRACE on that day on International Business Machines Corporation bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day. The red dots show the maximum yield in each International Business Machines Corporation issue recorded by TRACE. The black dots and connecting black line show the yield consistent with the best fitting trade-weighted credit spread explained below.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of International Business Machines Corporation. This is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for International Business Machines 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 (in black) that explains the trade-weighted average spread as a trade-weighted function of years to maturity. The polynomial explains 97.06% of the variation in credit spreads over the maturity spectrum.
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. For International Business Machines Corporation, the credit spread to default probability ratio generally ranges from 10 times to 20 times. The ratios of spread to default probability for all traded bond issues are shown here:
The credit spread to default probability ratios are shown in graphic form below for International Business Machines Corporation.
Are these reward to risk ratios "normal"? Are they above or below average? The best way to answer that question is to compare them to the credit spread to default probability ratios for all fixed rate non-call senior debt issues with trading volume of more than $5 million and a maturity of at least one year on February 7. The distribution of the 312 traded bonds that met these criteria on February 7 is plotted in this histogram:
The next graph plots the credit spread to default probability ratio for International Business Machines Corporation (dark blue) versus the other issuers with more than $5 million in trading volume on February 7. The line connects the median credit spread to default probability ratio for all issues.
The line varies because the issuers traded at each maturity point are different. Nonetheless, the dark blue dots representing the International Business Machines Corporation credit spread to default probability ratios are either at or slightly above the median at every point on the maturity spectrum.
91 out of 312 large trades on February 7 had better credit spread to default probability ratios than the best ratio for any of the International Business Machines Corporation bonds which traded at least $5 million in volume. Here are the 20 "best trades" done February 7, 2014 that had the highest ratios of credit spread to default probability. We have also reproduced the credit spread to default probability ratios for bond trades over $5 million in volume for International Business Machines Corporation. These bonds ranked from 92nd to 162nd of the 312 large trades on February 7.
Credit Default Swap Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended January 31, 2014 (the most recent week for which data is available), the credit default swap trading volume on International Business Machines Corporation was 5 trades for $71 million, a small fraction of the trading in the company's bonds.
The average daily number of non-dealer credit default swap contracts traded on International Business Machines Corporation in the 181 weeks ended December 27, 2013 was 1.23 contracts according to a recent report on CDS trading volume from Kamakura Corporation. The graph of the gross weekly number of contracts traded is shown here:
The notional principal of credit default swap trading on International Business Machines Corporation is shown in this graph:
On a cumulative basis, the default probabilities for International Business Machines Corporation range from 0.00% at 1 year to 0.80% at 10 years.
Over the last decade, the 1 year and 5 year annualized default probabilities for International Business Machines Corporation have remained at a low level that many of the largest financial institutions in the world would envy. The 1 year default probability peaked at about 0.05% in 2009. The 5 year default probability peaked at slightly under 0.10% in 2005.
As explained earlier in this note, the firm's default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. Over a long period of time, macro-economic factors drive the financial ratios and equity market inputs as well. If we link macro factors to the fitted default probabilities over time, we can derive the net impact of macro factors on the firm, including both their direct impact through the default probability formula and their indirect impact via changes in financial ratios and equity market inputs. The net impact of macro-economic factors driving the historical movements in the default probabilities of International Business Machines 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 International Business Machines Corporation default risk responds to changes in 3 risk factors among the 28 world-wide macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 56.2% of the variation in the default probability of International Business Machines Corporation. The remaining variation is the estimated idiosyncratic credit risk of the firm.
International Business Machines Corporation can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the USA "software and services" sector, International Business Machines Corporation has the following percentile ranking for its default probabilities among its 54 peers at these maturities:
1 month 11th percentile
1 year 15th percentile
3 years 6th percentile
5 years 1st percentile (lowest)
10 years 1st percentile (lowest)
Over a time horizon of 5 years or more, International Business Machines Corporation is the safest firm in its sector from a credit risk perspective. Taking still another view, the actual and statistically predicted International Business Machines Corporation credit ratings both show a rating strongly in the "investment grade" territory. The statistically predicted rating is 2 notches below the legacy rating, those of Moody's (MCO) and Standard & Poor's (MHFI). The legacy credit ratings of International Business Machines Corporation have changed once in the last decade.
Before reaching a final conclusion about the "investment grade" status of International Business Machines Corporation, we look at more market data. First, we look at International Business Machines Corporation credit spreads versus credit spreads on every bond in the technology, media, and telecommunications sector that traded on February 7:
International Business Machines Corporation credit spreads were clearly lower than average for the peer group. We now look at the matched maturity default probabilities on those traded bonds for both International Business Machines Corporation and the peer group:
The default probabilities for International Business Machines Corporation are in the lowest range of the industry peer group. We now turn to the legacy "investment grade" peers. First we compare traded credit spreads on February 7, 2014:
Again, International Business Machines Corporation credit spreads are at the low end of the peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on February 7 are shown in this graph:
Again the default probabilities for International Business Machines Corporation rank at the low end of the peer group.
We believe that a very strong majority of sophisticated analysts would rank International Business Machines Corporation as an investment grade company. The long run default probability outlook is still the best of its peer group, and default probabilities have varied in a very narrow band over the last decade.
We remind readers that a below average default probability is not sufficient reason to buy a bond. The bond must offer "good value," which we define in terms of the ratio of credit spread to the matching maturity default probability. By this measure, International Business Machines Corporation bonds offer a credit spread to default probability ratio that is slightly above the median for all bonds which traded at least $5 million on February 7. While this may not be an endorsement that excites some investors, it is a far better reward to risk ratio than many of the iconic brand names that have been reviewed in this series to date.
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.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.