Westpac Banking Corporation (NYSE:WBK) (OTCPK:WEBNF) is Australia's second largest bank by assets and has Australia's largest branch network. Investors in North American financial institutions seem overly-focused on names like Bank of America (NYSE:BAC), which has 97 times the retail following than Westpac Banking Corporation. That disparity often spells opportunity, so we ask the question, "What is the current bond market view of Westpac Banking Corporation?" This is an easy question to answer in light of Westpac Banking Corporation's 5-year covered bond offering in the United States last month. Today's study incorporates 51 June 4 bond trades on 15 U.S. dollar bonds issued by Westpac Banking Corporation with trading volume of $84.8 million. We use this bond price data to analyze the potential risk and return to bondholders and common shareholders of Westpac Banking Corporation. We also comment on the counterparty credit risk insights that one can derive from the same data, particularly from the bank's zero coupon credit spreads.
Conclusion: Put simply, Westpac Banking Corporation offers exceptionally good credit quality. We believe sophisticated analysts would be nearly unanimous in assessing the firm as investment grade. Just as important, Westpac Banking Corporation bonds offer exceptionally good value. Only 5 of 422 heavily traded bonds offered better value, as measured by the credit spread to default probability ratio, than the best Westpac Banking Corporation bond issue.
Our first objective is answer whether or not Westpac Banking Corporation would be considered "investment grade" in light of the changed definition of investment grade mandated by the Dodd-Frank Act and recently implemented by the U.S. Office of the Comptroller of the Currency. For background on Dodd-Frank and related regulatory changes, see our December 6 analysis of Citigroup Inc. (NYSE:C).
In this note, we analyze the current levels and past history of default probabilities for Westpac Banking Corporation. We also measure the reward, in terms of credit spread, for taking on the default risk of Westpac Banking Corporation bonds.
Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority for 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. We analyze the maturities where the credit spread to default probability ratio is highest for Westpac Banking 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 Westpac Banking Corporation ranging from one month to 10 years on an annualized basis. The current default probabilities, graphed in green, range from 0.00% at one month (note the default probability is positive but is rounded to zero) to 0.00% at 1 year (also after rounding) and 0.04% at ten years. The yellow line shows the levels of Westpac Banking Corporation exactly six months earlier.
We explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation on Seeking Alpha.
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. On June 4, 2014, Westpac Banking Corporation ranked 15th in trading volume in the U.S. bond market with $91.2 million. We use only the senior non-call debt issues in this note.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Westpac Banking 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 Westpac Banking Corporation. The second lowest 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 third curve from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on Westpac Banking Corporation bonds. The fourth line from the bottom (the green dots) displays the average yield reported by TRACE on the same day. The highest yield (the red dots) is obviously the maximum yield in each Westpac Banking Corporation issue recorded by TRACE. For the reader's convenience, we have added a trade volume-weighted credit spread, fitted to the trade-weighted average credit spread at each maturity. This curve is shown as black dots joined by black line segments.
The data makes it clear that there is a steady liquidity premium built into the yields of Westpac Banking Corporation above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm). Note that the default probabilities for Westpac Banking Corporation are so low as to be almost indistinguishable on the graph, in the light blue.
The high, low and average credit spreads at each maturity are graphed below.
The zero coupon credit spreads and zero coupon bond yields for Westpac Banking Corporation are shown in this graph versus zero coupon U.S. Treasury yields. The zero coupon data is provided by Kamakura Risk Information Services. We showed in a recent note on General Electric Company (NYSE:GE) how we can restate the dividend yield on a credit-adjusted basis. We leave that to the reader. Another important use of these zero coupon credit spreads is the assessment of the counter-party credit risk of Westpac Banking Corporation, with whom another institution might have trades settling in 1, 2, or more days. By discounting the cash owed by Westpac Banking Corporation at the zero coupon yields shown below, the analyst has a mark-to-market indicator of the costs of dealing with a counterparty whose default risk is not zero. Since there are no risk-free counterparties in today's world, this is an important calculation.
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. This ratio of spread to default probability is shown in the following table for Westpac Banking Corporation. At maturities under 1 year, the reward from holding the bonds of Westpac Banking Corporation, relative to the matched maturity default probability, is literally hundreds of times the very low short run default probabilities for Westpac Banking Corporation. The ratio of spread to default probability decreases with maturity after that, ranging from 15 to 87 times. These ratios are among the highest we have seen in this series of credit reports.
The credit spread to default probability ratios are shown in graphic form here. We have again added a traded-weighted polynomial (shown in black) relating the fitted credit spread-default probability ratio to the years to maturity on the underlying bonds.
Relative Value Analysis
Is the reward to risk ratio for Westpac Banking Corporation higher than average, lower than average, or just average? Rather than guess, we simply look at the facts. The chart below shows the credit spreads for all fixed rate senior non-call debt issues that traded at least $5 million in volume on June 4, 2014 and had at least 1 year to maturity. There were 422 bond issues that met our criteria. The median credit spread was 0.813% and the average credit spread was 1.194%. This histogram shows the distribution of credit spreads available in the market place.
The next graph shows the distribution of the credit spread to default probability ratios for all 422 issues. The median ratio was 8.534 and the average ratio was 12.354.
How did Westpac Banking Corporation rank on June 4, 2014? There were only 5 of the 422 bond issues that offered a better credit spread to default ratio than the best ranked Westpac Banking Corporation bond. The four Westpac Banking Corporation bonds that traded at least $5 million were ranked 6, 44, 56 and 60 on the "best value" rankings of these 422 bond issues. Westpac Banking Corporation clearly is in the top 15% of all traded bonds by our "best value" definition, the ratio of credit spread to default probability.
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently prohibited by Kamakura Corporation's contract with the data vendor. We are working hard to change this so that we may make CUSIPs available in the future. In the meantime, CUSIPs for major issuers can be found easily with an internet search on web pages like this one from the New York Stock Exchange.
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 May 30, 2014 (the most recent week for which data is available), the credit default swap trading volume on Westpac Banking Corporation was only $10,300,000 in notional principal on 3 trades, ranking the bank as 883rd for the week. Weekly data from the DTCC from July 2010 onward results in this graph of the notional principal traded in credit default swaps on Westpac Banking Corporation.
The number of contracts traded by week over the same period are shown in this graph:
On a cumulative basis, the current default probabilities for Westpac Banking Corporation range from 0.00% at 1 year (after rounding) to 0.36% at 10 years, as shown in the following graph. The 10-year cumulative default probability for Westpac Banking Corporation is approximately 1/5 the level we found for Deutsche Bank (NYSE:DB), which we analyzed in a recent note.
Over the last decade, the 1-year and 5-year default probabilities for Westpac Banking Corporation have varied as shown in the following graph. The one-year default probability peaked at just under 0.16% in the first half of 2009 during the worst part of the credit crisis. The 5-year default probability (annualized) peaked at just over 0.13%. These peak levels would be the envy of most large American banks, which suffered heavily in the recent credit crisis.
The macro-economic factors driving the historical movements in the default probabilities of Westpac Banking 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 Westpac Banking Corporation default risk responds to changes in 4 factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 79.0% of the variation in the default probability of Westpac Banking Corporation. The remainder of the risk is the idiosyncratic default risk of Westpac Banking Corporation.
Westpac Banking 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 world-wide "banks" sector, Westpac Banking Corporation has the following percentile ranking for its default probabilities among its 1,334 peers at these maturities:
1-month 0th percentile, tied with a large number of firms
1-year 0th percentile, tied
3 years 2nd percentile
5 years 1st percentile
10 years 1st percentile
The percentile ranking for Westpac Banking Corporation is among the very best analyzed in this series of notes.
The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill's (MHFI) unit Standard & Poor's and Moody's (NYSE:MCO), for Westpac Banking Corporation have changed twice in the last decade. A comparison of the legacy credit rating for Westpac Banking Corporation with predicted ratings indicates that the statistically predicted rating is two notches lower than the actual legacy credit rating. Both the actual and predicted ratings are in the middle of the investment grade range.
Before reaching any conclusions about investment grade status, it is useful to look at some additional market views of Westpac Banking Corporation and its peers. The following graph compares the traded credit spreads on Westpac Banking Corporation with the traded credit spreads on the "Banks/Finance" peer group on June 4, 2014:
The credit spreads for Westpac Banking Corporation were among the lowest spreads in the peer group. We now look at the matched-maturity default probabilities for Westpac Banking Corporation versus that same peer group. Westpac Banking Corporation default probabilities are also among the very lowest in the peer group. We remind the reader that the bonds that trade in the secondary market are typically the strongest credits in any given peer group, so this is a stricter standard than the percentile rankings we gave above.
We now compare the traded credit spreads for Westpac Banking Corporation with the traded spreads for every firm with a legacy credit rating in the old-style "investment grade" range. Again, Westpac Banking Corporation spreads are well below the median.
By the matched maturity default probability criterion, comparing to investment grade firms with bond trades on June 4, Westpac Banking Corporation's default probabilities are among the very lowest among the investment grade peer group.
With this data in mind, we draw some dispassionate conclusions that are quite similar to our conclusions in a recent note on the Bank of Nova Scotia (NYSE:BNS). Put simply, Westpac Banking Corporation offers exceptionally good credit quality and we believe sophisticated analysts would be nearly unanimous in assessing the firm as investment grade. Just as important, Westpac Banking Corporation bonds offer exceptionally good value. Only 5 of 422 heavily traded bonds offered better value, as measured by the credit spread to default probability ratio, than the best Westpac Banking Corporation bond issue.
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. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.