Warren Buffett, called by many as "America's greatest investor," celebrated his 83rd birthday on August 30, 2013. Mr. Buffett's primary investment vehicle is, of course, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), which often issues debt through affiliate Berkshire Hathaway Finance Corporation. The latter firm is the beneficiary of a guarantee from Berkshire Hathaway Inc. This note focuses on the risk and return on the bonds of Berkshire Hathaway Finance Corporation to derive the bond market's perspective on the future for Berkshire Hathaway Inc. and its iconic leader Mr. Buffett. More importantly, we compare the value proposition of the firm's bonds with other heavily traded bonds on May 5, 2014. We do this clinically, using cold hard statistics and zero emotion, an unusual style rarely found among Berkshire Hathaway commentators.
Conclusion: Sophisticated analysts would be almost unanimous in their assessment of Berkshire Hathaway Inc. as an investment grade company. That being said, the firm has been downgraded twice in the last 4 years by legacy rating agencies, and the cumulative 10-year default risk of the firm has moved up slightly (from 0.36% to 0.39%) since September.
Regular readers of these notes know, however, that a low default probability is not reason enough to buy a bond. The bonds must be "good value" as measured by our criterion, the ratio of credit spread to default probability. Berkshire Hathaway Finance Corporation bonds rank in the top 20% of all bonds traded on May 5 when ranked by the credit spread to default probability ratio. The Berkshire Hathaway bonds do not rank in the top 10% of the "best value" rankings, however. 28 other bond issues offered better value than the most attractive of the heavily traded issues of Berkshire Hathaway Finance Corporation.
Today's note incorporates Berkshire Hathaway Finance Corporation's bond price data as of May 5, 2014. A total of 93 trades were reported on 11 senior fixed-rate non-call bond issues of Berkshire Hathaway Finance Corporation with trading volume of $40 million. There were also trades in Berkshire Hathaway Inc., but trading was fairly light and we ignore that data in this analysis.
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 Berkshire Hathaway Inc. to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. For more on the implications of Dodd-Frank for the definition of investment grade, the Office of the Comptroller of the Currency's implementation is a good summary.
Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority and 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 to default probability ratio is highest for Berkshire Hathaway Inc. There are other definitions of "best value" that one might use, but we reserve those measures for another note.
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 Berkshire Hathaway Inc. 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 (0.000594% before rounding) to 0.00% at 1 year (0.000542% before rounding) and 0.04% at ten years. The current default probabilities are graphed here in green versus the default probabilities that prevailed at the time of our earlier study, on September 27, 2013.
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 11 of the 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 Berkshire Hathaway Finance 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, interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of Berkshire Hathaway Finance 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 line graphs the lowest yield reported by TRACE on that day on Berkshire Hathaway Finance Corporation bonds. The green line displays the average yield reported by TRACE on the same day. The red line is the maximum yield in each Berkshire Hathaway Inc. issue recorded by TRACE. The black dots and connecting black line reflect yields consistent with a cubic polynomial fitted to trade-weighted credit spreads, as explained below.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Berkshire Hathaway Finance Corporation. This is a pattern seen usually with firms of high credit quality. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for Berkshire Hathaway Finance 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 that explains the trade-weighted average spread as a 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 Berkshire Hathaway Finance Corporation, the credit spread to default probability ratio ranges from 18 times to 86 times, ignoring one odd-lot trade and an issue very close to maturity. The long term reward to risk ratios are in the 18 to 30 range, down considerably from our September 27 report. The ratios of spread to default probability for all traded bond issues are shown here:
The same figures are reported below for both Berkshire Hathaway Inc. and Berkshire Hathaway Finance Corporation on September 27, 2013:
The credit spread to default probability ratios are shown in graphic form below for Berkshire Hathaway Finance Corporation on May 5:
Relative Value Analysis
How does our definition of "best value," the ratio of credit spread to default probability, rank the heavily traded issuers on May 5? We start to answer that question by looking at this histogram of all bond issues (senior, fixed-rate, non-call, and maturity over 1 year), which had at least $5 million in trading volume on May 5, 2014. There were 269 such issues.
The median credit spread plotted above was 0.807% and the average was 1.072%. The next graph is a histogram of the credit spread to default probability ratio for all 269 issues. The median ratio was 7.041 and the average was 10.825.
Where do the Berkshire Hathaway bonds rank on May 5? Clearly, the reward to risk ratios discussed above were well above the median and average ratios. It will surprise many readers, however, that 28 other bond issues had a better ratio of credit spread to default probability than the best Berkshire Hathaway Finance Corporation bond. The only other bond issued by Berkshire Hathaway Finance Corporation with at least $5 million in trading volume ranked 51st. Both bonds ranked in the second decile by our ranking criterion, from the 11th percentile to the 20th. Ten percent of all heavily traded bonds offered a better reward to risk ratio than the Berkshire Hathaway Finance Corporation issues. For the top 30 best value bond issues of May 2, 2014, please see this analysis on Seeking Alpha.
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 April 25, 2014 (the most recent week for which data is available), the credit default swap trading volume on Berkshire Hathaway Inc. was 176 trades for $1.06 billion. This volume, which is quite high for a high quality credit, ranks 15th of 956 reference names traded. This is a much higher trading volume than Berkshire Hathaway volume in the U.S. bond market, and that differential is often a sign of a divergence of opinion on the outlook for that reference name. The notional value of credit default swaps traded on Berkshire Hathaway Inc. since July 2010 is shown in this graph:
The weekly number of credit default swaps traded for Berkshire Hathaway Inc. is summarized in this graph:
On a cumulative basis, the default probabilities for Berkshire Hathaway Inc. range from 0.00% at 1 year (after rounding) to 0.39% at 10 years, a very low level of long-term default risk. The current level of cumulative default probabilities (shown in green) is up 0.03% at 10 years from the September 27, 2013 levels (shown in yellow).
Over the last decade, the 1 year and 5 year default probabilities for Berkshire Hathaway Inc. both peaked in 2008-2009 at less than 0.05%, the lowest peak among the firms analyzed in this series of notes.
The macro-economic factors driving the historical movements in the default probabilities of Berkshire Hathaway Inc. 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 Berkshire Hathaway Inc. default risk responds to changes in 5 risk factors among the 28 worldwide macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 57.9% of the variation in the default probability of Berkshire Hathaway Inc. The remaining variation is the idiosyncratic default risk of the firm.
Berkshire Hathaway Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (NYSE:MS) and reported by Compustat. For the US "insurance sector" sector, Berkshire Hathaway Inc. has the following percentile ranking for its default probabilities among its 120 peers at these maturities:
1 month 0 percentile, tied with 31% of industry
1 year 0 percentile, tied with 22% of industry
3 years 3rd percentile, 4th lowest
5 years 3rd percentile, 5th lowest
10 years 3rd percentile, 4th lowest
This is one of the best collections of percentile ranks of any firm analyzed so far in this series of bond studies.
In contrast to the daily movements in default probabilities graphed above, we turn to the legacy credit ratings for Berkshire Hathaway Inc., those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor's and Moody's (NYSE:MCO). Over the last decade, the ratings of Berkshire Hathaway Inc. changed twice, the most recent of the two downgrades coming in 2013. Readers may recall that Berkshire Hathaway Inc. was formerly rated AAA. Taking still another view, the actual and statistically predicted Berkshire Hathaway Inc. credit ratings both show a rating strongly in the "investment grade" territory. The statistically predicted rating is 3 notches below the legacy rating.
Before summarizing our conclusions, we need to compare Berkshire Hathaway Finance Corporation with peers in the "Banks/Finance" peer group. We first look at credit spreads for all bonds issued by that peer group which traded on May 5, 2014 (shown in light blue). The credit spreads for Berkshire Hathaway Finance Corporation are shown in dark blue.
Berkshire Hathaway Finance Corporation credit spreads are on the safest end, the low end, of the spectrum of credits spreads among peer firms. Next, we compare the matched-maturity default probabilities for those same bond issues with Berkshire Hathaway, in dark blue:
The default probabilities are among the lowest in the sector peer group. Next, we make the same comparison among Berkshire Hathaway and the legacy "investment grade" definition using traditional credit ratings. The next graph makes it clear that Berkshire Hathaway Finance Corporation credit spreads are at the low end of the peer group.
Investment grade default probabilities are plotted in the next graph. Again, Berkshire Hathaway is at the very low end of the range across all maturities.
Sophisticated analysts would be almost unanimous in their assessment of Berkshire Hathaway Inc. as an investment grade company. That being said, the firm has been downgraded twice in the last 4 years by legacy rating agencies, and the cumulative 10-year default risk of the firm has moved up slightly (from 0.36% to 0.39%) since September. This is still an exceptionally low level that almost all bond issuers would envy.
Regular readers of these notes know, however, that a low default probability is not reason enough to buy a bond. The bonds must be "good value" as measured by our criterion, the ratio of credit spread to default probability. By this measure, Berkshire Hathaway Inc. and Berkshire Hathaway Finance Corporation bonds are surprising in two dimensions. First, in spite of the iconic nature of the firm, the bonds rank in the top 20% of all bonds traded on May 5 when ranked by the credit spread to default probability ratio. Most of the iconic names reviewed previously in this series offer below average value. Second, the Berkshire Hathaway bonds do not rank in the top 10% of the "best value" rankings. 28 other bond issues offered better value than the most attractive of the heavily traded issues of Berkshire Hathaway Finance Corporation. For some readers of this note, this observation may seem almost blasphemous. To the analytically minded, however, these are just cold hard facts. Thanks for reading.
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.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.