Transocean Ltd. (NYSE:RIG) one-year default probabilities dropped 3.49% yesterday but still remain high at 15.30%.
Secondary corporate bond market trading remains very active. Transocean Ltd. was the most heavily traded bond issuer in the U.S. corporate bond market on December 16, as shown in this chart from Kamakura Risk Information Services:
Overall, there was $209.4 million of trading volume in Transocean and another $49.7 million of trading volume in affiliate Transocean Inc. on December 16, a total of 640 trades in 8 different bond issues.
Looking at trading in individual bond issues, Transocean bonds took 4 of the first 5 places and 6 of the top 10 places. The Transocean bonds due March 15, 2018, totaled more than $62 million in trading volume. The top 6 Transocean bonds all traded more than $31 million in volume each.
Credit spreads are widening dramatically for Transocean as well, with bonds that rank 5th, 7th, 8th, 9th, 13th and 19th in this graphic on the widest credit spreads in the U.S. fixed rate bond market.
"Widest spread" and "lowest price" are not always perfectly correlated if the risky bonds of an issuer are newly offered. Transocean now ranks among the lowest priced bonds. This chart shows that Transocean bond issues are 5th, 6th, 9th, 10th, 13th and 18th on the lowest price rankings.
Transocean ranked 17th among all reference names in credit default swap trading volume for the week ended December 12, the most recent week for which data is available, with more than $547 million in notional principal traded.
Weekly credit default trading volume on Transocean Inc. since July 2010 is shown here:
Are Transocean bonds worth buying, in light of their high default risk? From a "best value" perspective, we regularly rank bonds by the ratio of credit spread to default probability. By this ranking, Transocean's 7 most heavily traded bonds were ranked in the bottom 16 of the 197 heavily traded fixed rate bonds on December 16, 2014:
We stand by the July 15, 2014, assessment that the potential reward on Transocean bonds, relatively to its risk, is among the worst value propositions in the market.
Background on the Default Probability Models Used
The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model (abbreviated KDP-jc5) makes default predictions using a sophisticated combination of financial ratios, stock price history and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2,000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. KRIS covers 35,000 firms in 61 countries, updated daily.
Using Default Probabilities in Asset Selection
We recommend this introduction to the use of default probabilities in fixed income strategy by JPMorgan Asset Management.
General Background on Reduced Form Models
For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.
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