In this note we analyze the current levels and past history of default probabilities for Hewlett-Packard Company (HPQ), which we last reviewed on July 16, 2013. The company releases earnings after the market close today. We compare those default probabilities to credit spreads on 366 bond trades on 21 fixed rate non-call senior bond issues of Hewlett-Packard Company on February 19, 2014. These trades represented a notional principal amount of $94.7 million. We make a careful comparison of the reward to risk ratio for Hewlett-Packard versus all other bonds traded in the U.S. corporate bond market on February 19.
Conclusion: Hewlett-Packard Company has managed a dramatic 0.15% drop across the board reduction in annualized default risk since our July 16, 2013 report. Over a ten year cumulative period, this means there is 0.81% lower chance of a company bankruptcy than there was on July 16. We believe that the majority of analysts would rank Hewlett-Packard Company as an investment grade credit. The bad news is that the iconic nature of the HP "brand" has driven the credit spread to default probability ratio for the company to below average levels. Investors earn 4 to 6 times more in credit spread than the default probability on Hewlett-Packard Company. This is only half the level earned at the 10.34 median ratio on 369 bond trades for more than $5 million in the U.S. fixed rate senior debt market on February 19. This differential measures the cost of a "brand name."
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 Hewlett-Packard Company 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 Hewlett-Packard Company
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 (in green) for Hewlett-Packard Company ranging from one month to 10 years on an annualized basis, compared to the same default probabilities on July 15, 2013 (in yellow). 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 0.23% at one month to 0.12% at 1 year and 0.37% at ten years. Default probabilities for Hewlett-Packard Company have declined by about 0.15% across the full term structure of default probabilities since July 15, 2013, a very significant improvement from a credit risk perspective.
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 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 Hewlett-Packard 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 (TLT)(TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of the subsidiary Hewlett-Packard Company 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 yield reported by TRACE on that day on Hewlett-Packard Company bonds. The green dots display the value-weighted average yield reported by TRACE on the same day. The red dots represent the maximum yield in each Hewlett-Packard Company bond issue recorded by TRACE. The black dots and connecting line represent the yield consistent with the fitted trade-weighted credit spread described below.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Hewlett-Packard Company 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 spread at each maturity are graphed here, along with fitted credit spreads using a trade-weighted cubic polynomial. This polynomial explains 98.33% of the variation in credit spreads over the term structure:
Because we have 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 this table for Hewlett-Packard Company.
Over most of the 30 year term structure of credit spreads, the reward to risk ratio for Hewlett-Packard Company bonds ranges generally between 4 times to 6 times. This means that an investor gets a credit risk "reward" in terms of spread which is 4 to 6 times the default risk that the company has over the life of the bonds. The same ratios for July are shown here; for the most part the credit spread to default probability ratios are unchanged since July:
The next graph plots the ratio of credit spread to default probability at each maturity.
Are the credit spreads and the reward to risk ratio on Hewlett-Packard Company bonds below average, average, or above average? The best way to answer that question is to turn to all trading in the U.S. bond market in senior debt with maturities of one year or more and trading volume of at least $5 million in each bond issue on that day. The results of this comparison for credit spreads are shown in this histogram:
The mean credit spread for the 369 trades of $5 million or more and maturities of one year or longer was 1.18% on February 19, 2014. Of these 369 trades, only 25 trades had legacy ratings below the traditional ratings-based definition of "investment grade," now modified by the Dodd-Frank Act. The median credit spread on the 369 trades was 0.91%, and the largest credit spread over all of the trades was 7.13% on the 6.625% bonds due October 15, 2018 and issued by Sears Holding (SHLD).
Value means more to a sophisticated investor than the credit spread alone, so the next histogram compares the ratio of credit spread to matched-maturity default probability for all 369 trades of $5 million or more on February 19, 2014. The average spread to default probability ratio was 15.76, and the median was 10.34. The distribution of the credit spread to default probability ratio among these 369 trades is given here:
Since the Hewlett-Packard Company credit spread to default probability ratios were in the 4 to 6 range, the conclusion that the bonds offer "below average" values to investors is unavoidable. One would only invest in Hewlett-Packard Company bonds for diversification reasons, and only then if names offering better value were already at their portfolio limits. On February 19, the 20 bond issues offering the highest ratios of credit spreads to default probabilities were these bonds, led by Goldman Sachs Group Inc. (GS), Ecolab Inc. (ECL), and American Express Credit Corp. (AXP):
Credit Default Swap Analysis
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. The number of credit default swaps traded weekly on Hewlett-Packard Company since July 2010 is shown here. Please note that the volume of trading does not have a simple relationship to the company's credit risk. Instead, volume is driven by the diversity of opinions about the credit quality of the reference name. A greater diversity of opinion leads to more trading. A unanimity of opinion leads to zero volume because there is no one with a different opinion to trade with.
The weekly notional principal traded on Hewlett-Packard Company credit default swaps is shown in the next graph. Trading has been active since July 2012:
On a cumulative basis, the default probabilities for Hewlett-Packard Company range from 0.12% at 1 year (down 0.09% from July 15, shown in yellow) to 3.61% at 10 years. On July 15, 2013, the 10 year cumulative default probability for Hewlett-Packard Company was 4.42%, so there has been a very substantial 0.81% reduction in credit risk.
Over the last 10 years, the 1 year and 5 year default probabilities for Hewlett-Packard Company have varied as shown in the following graph. The one year default probability peaked at slightly over 1.80% in 2012 after spending most of the decade well below 0.40%.
Over the same decade, the legacy credit ratings for Hewlett-Packard Company have changed only twice.
The macro-economic factors driving the historical movements in the default probabilities of Hewlett-Packard Company over the period from 1990 to the present include four domestic risk factors of those listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 76.1% of the variation in the one year default probability of Hewlett-Packard Company since 1990.
Hewlett-Packard Company can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the USA "information technology" sector, Hewlett-Packard Company has the following percentile ranking for its default probabilities among its 913 peers at these maturities:
1 month 79th percentile, down 4 points since July
1 year 59th percentile, down 10 points since July
3 years 45th percentile, down 9 points since July
5 years 23rd percentile, down 6 points since July
10 years 18th percentile, down 2 points since July
The percentile ranking of the default probabilities for Hewlett-Packard Company, like the default probabilities themselves, have shown a considerable improvement since July 15, 2013. A comparison of the legacy credit rating for Hewlett-Packard Company with predicted ratings indicates that the company is overrated by one ratings grade.
Before summarizing our assessment of whether Hewlett-Packard Company is "investment grade," we look at the market's assessment. First we look at the company's credit spreads compared to all credit spreads for peer companies in the "technology, media and telecommunications" sector that traded on February 19:
Hewlett-Packard Company credit spreads are solidly in the middle of the pack. When we make the same comparison to the industry sector peer default probabilities based on February 19 trades, we get the following results:
Hewlett-Packard Company default probabilities are close to the levels cited above for the full industry sector universe. Now we turn to trades on bonds with a legacy ratings-based "investment grade" rating. Again, Hewlett-Packard Company is in the middle of the group from a credit spread perspective:
When it comes to the comparison with the matched-maturity default probabilities for the same investment grade peer group, Hewlett-Packard Company is, if anything, slightly above the median for the peer group.
Hewlett-Packard Company has experienced considerable volatility in its default probabilities in recent years, but the large drop in default probabilities since our July 15, 2013 report is a sign of significant progress. At current default probability levels, Hewlett-Packard is in the riskier half of its peers for maturities ranging from 1 month to 1 year. At maturities of 5 and 10 years, however, the company ranks in the safest one-quarter of its peer group. While a prudent investor should monitor this credit closely, we believe that most sophisticated analysts would rate Hewlett-Packard Company as investment grade by the Comptroller of the Currency definition. That is not sufficient reason to buy a bond, however. It may be necessary, but it's not sufficient. The credit spread to reward ratio for Hewlett-Packard Company is below average, as proven by the comparison with the 369 large trades on February 19. This is a phenomenon we have seen often with the bonds of issuers with "iconic" brand names: investors of all types will pay more for the bonds of such companies than they will for "no brand" or "boring brand" companies. The result is a lower reward relative to the credit risk being taken.
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.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.