Special disclosure by the author: The author spent two summers working under Wm. Mack Terry, head of the Financial Analysis and Planning Department, at Bank of America NT & SA in San Francisco nearly 40 years ago. One of Mack's key lessons, for both senior management and for me, was that the devil and the solution to a puzzle were both in the details.
While investors and bank management await the official release of the annual stress tests by U.S. bank regulators, the bond market is providing real-time assessments of the creditworthiness of major U.S. banks, including Bank of America Corporation (NYSE:BAC). While the stress testing process is expensive, on March 7 alone investors put $174.3 million into their credit assessment of Bank of America Corporation. We last analyzed default risk at Bank of America Corporation on December 3, 2013, a follow-on to earlier analyses on August 20, 2013 and July 8, 2013. In the July post, we also reported on an extensive May 25, 2011 analysis of the credit crisis history of consolidated Bank of America borrowings (including borrowings of Countrywide Financial and Merrill Lynch) from the Federal Reserve and the events leading up to those borrowings. Bank of America consolidated borrowings during the credit crisis peaked at $48.1 billion, nearly double the amount of money that Lehman Brothers requested but did not get from the Federal Reserve prior to its bankruptcy filing on September 14, 2008. Today's study incorporates Bank of America bond price data as of March 7, 2014 to re-analyze the potential risk and return to bondholders of Bank of America Corporation. We use 538 trades on 88 Bank of America Corporation bond issues and a trading volume of $174.3 million in today's analysis.
Conclusion: We believe a majority of analysts would judge the Bank of America Corporation to be slightly above the border between investment grade and non-investment grade. Bond investors have been kind to Bank of America Corporation, bidding up bond prices to the point where the credit spread to default probability ratio is well below the median for large trades on March 7. We have seen this phenomenon often with iconic brand names. For investors who care only about risk and return instead of the brand name, 224 different bond issues on March 7, 2014 offered a better reward to risk ratio than the most attractive Bank of America bond.
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 Bank of America 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 (NYSE: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 Bank of America 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 Bank of America 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 current default probabilities, in green, range from 0.13% at one month (up 0.01% from November) to 0.06% at 1 year (unchanged from November) and 0.43% at ten years (down 0.05%). The November 29, 2013 default probabilities used in the December 3 study are shown in yellow.
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 all of the 88 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 Bank of America 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 (NYSEARCA:TLT)(NYSEARCA:TBT), interpolated from the Federal Reserve H15 statistical release for that day, which exactly matches the maturity of the traded bonds of Bank of America 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 Bank of America 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 Bank of America 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 a generally increasing "liquidity premium" as maturity lengthens for the bonds of Bank of America Corporation, with a peak in credit spread at about 20 years to maturity. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for Bank of America 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.
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 Bank of America Corporation, the credit spread to default probability ratio generally ranges widely from about 5 times to 15 times. For the longer maturities, shown in the second table, the credit spread to default probability ratio falls to a range from 2 to 9 times.
The longest maturity Bank of America Corporation bond issues are analyzed in this chart:
The same analysis from November 2013 is reproduced here:
The credit spread to default probability ratios are shown in graphic form below for Bank of America Corporation. The graph shows the steady decline in the credit spread to default probability ratio once the bond maturity exceeds about 3 years.
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 March 7. The distribution of the credit spreads on the 397 traded bonds that met these criteria on March 7 is first plotted in this histogram:
The median credit spread for all 397 trades was 0.94%. The average credit spread was 1.24%. The next graph shows the wide dispersion of the credit spread to default probability ratios on those 397 March 7 trades:
The median credit spread to default probability ratio on those 397 trades was 9.50 and the average was 16.49. A total of 224 out of 397 large trades on March 7 had better credit spread to default probability ratios than the best ratio for any of the Bank of America Corporation bonds that traded at least $5 million in volume. Here are the 20 "best trades" done March 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 Bank of America Corporation. The Bank of America Corporation bonds (along with one issue by Bank of America NA) ranked 225th through 346th of the 397 large trades on March 7.
Credit Default Swap Analysis
For the week ended February 28, 2014 (the most recent week for which data is available), the Depository Trust & Clearing Corporation reported 36 trades with notional principal of $430 million on Bank of America Corporation. Note this is much lower trading volume (on average $86 million per day) than in the U.S. bond market for Bank of America Corporation. The weekly number of credit default swap trades on Bank of America Corporation since the DTCC began publicizing weekly trade volume is shown here:
The notional principal of credit default swap trading on Bank of America Corporation over the same period is shown in this graph:
On a cumulative basis, the default probabilities for Bank of America Corporation range from 0.06% at 1 year to 4.23% at 10 years. The current cumulative default probabilities, shown in green, have dropped considerably since our analysis using data from November 29, 2013 (shown in yellow).
Over the last decade, the 1 year and 5 year annualized default probabilities for Bank of America Corporation show the huge shock posed by the credit crisis and the huge benefit of the $45 billion U.S. government capital injection. The 1 year default probability peaked at more than 20% in 2009. The annualized 5 year default probability peaked at slightly more than 5.00% in the same year.
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 Bank of America 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 Bank of America Corporation default risk responds to changes in 6 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 63.6% of the variation in the default probability of Bank of America Corporation. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Bank of America Corporation can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the U.S. "diversified financials" sector, Bank of America Corporation has the following percentile ranking for its default probabilities among its 223 peers at these maturities:
1 month 87th percentile
1 year 78th percentile
3 years 73rd percentile
5 years 62nd percentile
10 years 63rd percentile
For all time horizons, Bank of America default probabilities are in the riskier half of the peer group. Taking still another view, the actual and statistically predicted Bank of America Corporation credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is 2 notches below the legacy rating, those of Moody's (NYSE:MCO) and Standard & Poor's (MHFI). The legacy credit ratings of Bank of America Corporation have changed six times in the last decade.
Before reaching a final conclusion about the "investment grade" status of Bank of America Corporation, we look at more market data. First, we look at Bank of America Corporation credit spreads versus credit spreads on every bond in the "Banks/Financials" sector that traded on March 7:
Bank of America Corporation credit spreads were near the average for the peer group. We now look at the matched maturity default probabilities on those traded bonds for both Bank of America Corporation and the peer group:
Consistent with the percentile rankings above, the default probabilities for Bank of America Corporation are above the average of the industry peer group. We note that the bonds trading heavily are generally a much better group of credits than the industry in aggregate. We now turn to the legacy "investment grade" peers. First we compare traded credit spreads on March 7, 2014:
Again, Bank of America Corporation credit spreads are near the average of the investment grade peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on March 7 are shown in this graph:
Again, the default probabilities for Bank of America Corporation rank at or above the median for the investment grade peer group.
Our conclusions from December 3 and August 20 are unchanged. Although Bank of America Corporation default probabilities have continued to drop, Bank of America Corporation still ranks in the riskier half of the diversified financial services sector from a credit risk perspective. The $45 billion of capital injected into Bank of America Corporation (initially a portion was invested via Merrill Lynch) is concrete evidence of two things: the bank was considered "too big to fail" and the bank was going to fail (see the title of the October 5, 2009 report by the Special Inspector General of the Troubled Asset Relief Program) without such support. We believe that most analysts would predict that the U.S. government would again rescue the bank if necessary. The Kamakura default probabilities used above do NOT make this assumption. The probability of rescue is ignored; the Kamakura default probabilities are the probability of failure. We believe most analysts feel the probability of rescue is embedded in the current legacy ratings for Bank of America Corporation. The same is true for credit spreads. The statistically predicted rating does not include this probability, which is one reason why the statistically predicted rating is two notches lower.
We believe a majority of analysts would judge the bank to be slightly above the border between investment grade and non-investment grade. Bond investors have been kind to Bank of America Corporation, bidding up bond prices to the point where the credit spread to default probability ratio is well below the median for large trades on March 7. We have seen this phenomenon often with iconic brand names. For investors who care only about risk and return instead of the brand name, 224 different bond issues on March 7, 2014 offered a better reward to risk ratio than the most attractive Bank of America bond.
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.