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Summary

  • Hewlett-Packard was the second most heavily traded issuer in the U.S. fixed rate corporate bond market on July 7.
  • The firm's 10-year cumulative default risk has plunged from 4.42% on July 16, 2013 to 2.95% today.
  • The "brand name" effect, however, has led investors to bid up the firm's bond prices so that the credit spread to default probability ratio is slightly below average.

Hewlett-Packard Company (NYSE:HPQ) ranks number 31 on the Forbes list of the world's most valuable brands. We have seen often in this series of notes that there can be brand premium in bond prices that often keeps brand name companies from being "good value" for bond investors. In this note, we examine that question for Hewlett-Packard Company. We turn to the U.S. dollar bonds issued by Hewlett-Packard Company and compare its current default probabilities and credit spreads with those on all heavily traded corporate fixed-rate bonds on July 7, 2014. A total of 194 trades were reported on 15 fixed-rate bond issues of Hewlett-Packard Company with July 7 trading volume of $93.6 million. We use this information for three purposes: to evaluate the risk and return on the firm's bonds, to evaluate the firm's credit risk-adjusted dividend yield, and to reach a conclusion on investment grade status by the modern "Dodd-Frank" definition.

Conclusion: Hewlett-Packard Company has managed a second dramatic 0.15% across the board reduction in annualized default risk since our February 19, 2014 report, after a similar reduction following our July 16, 2013 report. The 10-year cumulative default probability has fallen from 4.42% on July 16, 2013 to 2.95% now. This 1.47% reduction in 10-year cumulative default risk is a major accomplishment. We believe that an increasing 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" is such that credit spreads are still narrow relative to default risk compared to other heavily traded bond issues on July 7. Five of the 7 heavily traded Hewlett-Packard Company bond issues had credit spread to default probability ratios below the median on July 7. This differential measures the cost of a "brand name."

The 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 Hewlett-Packard Company to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. For a discussion of the implications of the Dodd-Frank Act on the definition of investment grade, see our post on Citigroup in December.

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. In this note, we also analyze the maturities where the credit spread to 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 for Hewlett-Packard Company (green line) ranging from one month to 10 years on an annualized basis. We plot the current default probabilities versus the default probabilities for Hewlett-Packard Company at the time of our last study, February 19, 2014 (orange line). 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 0.09% at one month (down 0.14% from February) to 0.03% at 1 year (down 0.09%) and 0.30% at ten years (down 0.07%). Default probabilities for Hewlett-Packard Company have now declined by about 0.25% across the full term structure of default probabilities since our July 15, 2013 report, a very significant improvement from a credit risk perspective.

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We also 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. The total of all fixed rate debt issued by Hewlett-Packard Company and traded on July 7 is reported here. Hewlett-Packard Company was the second most actively traded issuer.

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Trading volume by issue is shown in the next chart, with 2 Hewlett-Packard Company bonds ranking in the 20 most actively traded fixed rate non-call senior bonds.

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We used all of the Hewlett-Packard Company bond trades in this study.

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 (NYSEARCA:TLT) (NYSEARCA:TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of 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 line graphs the lowest yield reported by TRACE on that day on Hewlett-Packard Company bonds. The green line displays the value-weighted average yield reported by TRACE on the same day. The red line is the maximum yield in each Hewlett-Packard Company bond issue recorded by TRACE. The black dots and connecting black line represent the yields consistent with a trade-weighted fitted credit spread we discuss below.

The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Hewlett-Packard Company. This increasing liquidity premium is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.

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The high, low, average, and fitted credit spreads at each maturity are graphed below for Hewlett-Packard Company. We have done nothing to smooth the data reported by TRACE (other than eliminating erroneous data as explained above), which includes both large lot and small lot bond trades. For the reader's convenience, we fitted a trade-weighted cubic polynomial that explains the average spread as a function of years to maturity.

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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 Hewlett-Packard Company, the credit spread to default probability ratio ranges from 4.5 to more than 14.5 times. The ratios of spread to default probability for all traded bond issues are shown here:

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The credit spread to default probability ratios are shown in graphic form below for Hewlett-Packard Company.

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Relative Value Analysis

How does the credit spread to default probability ratio for Hewlett-Packard Company compare to other bonds available in the market place? Is it high, low or average? We answer that question by comparing the credit spread to default probability ratio for Hewlett-Packard Company with all 215 fixed-rate non-call senior bond issues with a daily trading volume of at least $5 million on July 7 and a maturity of 1 year or more. The first graph shows a histogram of the credit spreads that prevailed on these issues on July 7, 2014:

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The median credit spread was 0.752% and the average was 1.027%. The distribution of the reward to risk ratio, the credit spread divided by the matched maturity default probability, is shown in the next histogram. The median ratio is 8.619 and the average ratio is 16.481.

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The ratio of credit spread to default probability is shown in this chart for all of the Hewlett-Packard Company bonds with at least $5 million in trading volume. The seven heavily traded Hewlett-Packard Company bonds rank 76, 103, 126, 130 and 136 to 138. Two of the issues rank above the 108th bond, the median of all heavily traded bonds when ranked by our value criterion. Overall, the Hewlett-Packard Company bonds rank below the median credit spread to default probability ratio.

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CUSIPs

Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is illegal under 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-Adjusted Dividend Yield

We explained in a recent post on General Electric Company (NYSE:GE) how default probabilities and the associated credit spreads for a bond issuer can be used to calculate the credit-adjusted dividend yield on a stock. That analysis makes use of a comparison between the yield on the issuer's promise to pay $1 in the future versus the yield on a similar promise by the U.S. government to pay $1 at the same time. Using the maximum smoothness approach to both the U.S. Treasury curve and to Hewlett-Packard Company credit spreads, we can generate the zero coupon bond yields on their promise to pay $1 in the future, which are shown in this graph:

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The widening of zero coupon credit spreads is important. If we discount dividend payments for maturities of 1, 10 and almost 30 years, we can solve for the "credit risk free" dividend for Hewlett-Packard Company. This would be the dividend level for a default risk-free issuer (we assume as a first approximation that the U.S. Treasury is default risk-free) that has the same present value as the flow of dividends from Hewlett-Packard Company over almost 30 years. We use this data from Seeking Alpha:

The history of Hewlett-Packard Company dividends is nicely summarized on the company website.

Readers who prefer a real time update of the dividend yield information can see that here. After projecting the flow of dividends from Hewlett-Packard Company at the quarterly rate of $0.16 and using the present value factors implied by Hewlett-Packard Company bond prices, we find that the long-term credit-adjusted dividend yield is 1.591%, 0.417% less than the traditional dividend yield of 1.908% (note that the yield on the Seeking Alpha website is different because of lags in updating the figure as the stock price changes). Both calculations assume that the dividends remain at their current level forever, except in the credit-adjusted case we recognize that Hewlett-Packard Company may default, ending the dividend stream. The bond-based discount factors incorporate this fact. We show the calculation below for just the first 24 months of cash flows.

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 June 27, 2014 (the most recent week for which data is available), the credit default swap trading volume on Hewlett-Packard Company was 75 trades for $888 million, ranking the firm 66th among 956 counterparties with at least one trade during the week.

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The notional principal traded weekly in the credit default swap market on Hewlett-Packard Company is shown in this graph of data from the Depository Trust & Clearing Corporation:

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The number of credit default swaps traded weekly on Hewlett-Packard Company is shown in this history graph:

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Additional Analysis

On a cumulative basis, the current default probabilities (in green) for Hewlett-Packard Company range from 0.03% at 1 year to 2.95% at 10 years. The February 19, 2014 cumulative default probabilities are graphed in orange.

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Over the last decade, the 1-year and 5-year annualized default probabilities for Hewlett-Packard Company spiked during the 2012-2013 crisis of confidence in the firm's future. The 1-year default probability (in blue) peaked at slightly over 1.80%. The 5-year default probability (in yellow) peaked at more than 0.80% on an annualized basis at the same time.

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The firm's default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. For an explanation, see the references in each Instablog posted by Kamakura Corporation. 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 Hewlett-Packard Company has 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 Hewlett-Packard Company default risk responds to changes in 4 risk factors among the macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 76.1% of the variation in the default probability of Hewlett-Packard Company. The remaining variation is the estimated idiosyncratic credit risk of the firm.

Hewlett-Packard Company 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 "technology, hardware and equipment" sector, Hewlett-Packard Company has the following percentile ranking for its default probabilities among its 314 peers at these maturities:

1-month 69th percentile

1 year 37th percentile

3 years 21st percentile

5 years 11th percentile

10 years 10th percentile

Over the longest time horizons, Hewlett-Packard Company ranks in the safest 11% of its peer group from a credit risk perspective.

Taking still another view, the actual and statistically predicted Hewlett-Packard Company credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is 1 notch below the legacy rating from firms like the Standard & Poor's affiliate of McGraw-Hill (NYSE:MHFI) and Moody's Investors Service (NYSE:MCO). The legacy ratings of the company have changed twice in the last decade.

Conclusions

We postpone our conclusions briefly to view some more facts. The "technology, media and telecommunications" peer credit spreads on July 7 are shown here in light blue, with Hewlett-Packard Company credit spreads plotted in dark blue. Hewlett-Packard Company credit spreads are near the median. We remind readers that the traded bond peer group generally has higher average quality than the full peer group universe.

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The matched maturity default probabilities for the "technology, media and telecommunications" peer group with bonds traded on July 7 are shown in this graph:

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Hewlett-Packard Company is among the lower default probabilities of the peer group by this measure. Investment grade credit spreads on all bonds traded on July 7 are shown here in light blue with Hewlett-Packard Company credit spreads plotted in dark blue:

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Hewlett-Packard Company falls near to but below the middle of the investment grade peer group. Investment grade peer group default probabilities are shown in this graph versus Hewlett-Packard Company:

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Hewlett-Packard Company is again near the safer part of the investment grade peer group.

Conclusion: Hewlett-Packard Company has managed a second dramatic 0.15% across the board reduction in annualized default risk since our February 19, 2014 report, after a similar reduction following our July 16, 2013 report. The 10-year cumulative default probability has fallen from 4.42% on July 16, 2013 to 2.95% now. This 1.47% reduction in 10-year cumulative default risk is a major accomplishment. We believe that an increasing 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" is such that credit spreads are still narrow relative to default risk compared to other heavily traded bond issues on July 7. Five of the 7 heavily traded Hewlett-Packard Company bond issues had credit spread to default probability ratios below the median on July 7. This differential measures the cost of a "brand name."

Author's Note

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.

Source: Hewlett-Packard Company Bonds: Default Risk Continues To Drop