The objective of this write-up is to showcase how the Kamakura Risk Information Services (“KRIS”) default probabilities subscription service assists users to manage exposure ingress and egress based on Kamakura Default Probabilities (“KDP”) movements.
On September 12 2016, Samsung Electronics Company Ltd. (KRX: 005930) (“Samsung”) announced the recall of all of its flagship cellphones in the Galaxy Note 7 series. The organization decided on this action on the back of several damaging incidents relating to the phones catching fire due to overheated batteries.
Samsung has faced a serious issue with Galaxy Note 7 phones that have a high propensity of batteries failing, leading to personal and property damage. In the original, pre-recall Note 7, hundreds of phones worldwide had critical failures. The phone was recalled officially in the U.S. once, and Samsung launched exchange programs in other countries. But the new models continued to see further issues, with the replacement catching on fire in early October. This led to Samsung telling Note 7 owners to stop using the phones and return them, before permanently discontinuing the Note 7. Shortly thereafter, the U.S. Consumer Protection Safety Commission officially issued a second recall.
This document highlights how KRIS and related risk measures showcase the inherent strength of Samsung and its creditworthiness being unaffected even with this seriously damaging news.
The default probabilities produced by the KRIS service include both the best practice reduced form default probabilities and the older and less accurate Merton model default probabilities. In this note, we use the KRIS version 6.0 reduced form default probabilities, the newest and most accurate model in the KRIS default models framework.
The chart below shows the history of the 1-year (in blue) and 10-year (in orange) default probabilities for Samsung:
The rationale for selecting history from September 2016 was to draw reference the first recall story, and to evaluate whether there has been any impact on Samsung’s creditworthiness because of this news, which obviously would have enormous financial implication. It certainly had a significant impact on its stock prices, as can be seen in the adjacent graphic, where the stock prices immediately took a drop in the aftermath of the news story relating to the recall breaking, recovering, and then falling again after further recall news items in the past week. However, it is our contention that Samsung has a significantly diverse product mix which ensures that even this potentially adverse event has not had a significant impact on its KDP.
In Kamakura Corporation’s popular troubled company index, a firm is considered “troubled” if its default probability exceeds one percent. The graph above clearly shows that the 1-year default probability of Samsung never exceeded 1.00%, and neither did the 10-year KDP. For a fixed income investor, this is tremendously comforting, and highlights hold options even through troubled times.
Another important metric in KRIS is the cumulative default probability for the issuer. On October 12, 2016, the cumulative 10-year default probability for Samsung is a very reasonable 0.23%. This metric too, indicates the inherent strength of Samsung and is a signal to the fixed income investor to not panic.
A third analytic in the KRIS portfolio of outputs is the actual traded bond prices on the company’s outstanding bond issues, from which credit spreads can be computed, and this represents an unimpeachable relationship between creditworthiness and the performance of the company.
It can be seen clearly from the graphic above that there was no impact on bond prices through the recall period, and Samsung’s probability of default also did not evidence any spikes when the recall news hit the wires.
The changing landscape has had no lasting impact on Samsung bond spreads, as can be evidenced by the graph below, where the spreads have largely remained within a close cluster of 10-20 basis points through 2016, and as indicated earlier, the KDPs have not been impacted in any way whatsoever.
Another indicator that is very valuable as an early warning signal is a comparison to the industry peer group, which in the case of Samsung is the Technology Hardware & Equipment peer group. It can be seen clearly in the graph below that Samsung’s one-year default probability is much below median level of the peer group through 2015 and 2016, and this further reinforces the fact that the diversified nature of Samsung implies that adverse news on a particular product in itself is not going to have a debilitating impact on company performance.
Finally, a critical indicator that is provided by KRIS is the linking of macro factors to default probability functions, and an analysis of Samsung shows that their KDPs are directly linked to the EUR/USD exchange rate, the JPY/USD exchange rate, but not the Korean Stock Index. Since the performance of this organization is not directly related to its stock price, a drop in this risk factor indicator essentially meant that the KDPs of Samsung did not move in line. The figure above identifies the various macro factors that drive the creditworthiness of Samsung, and the figure below indicates that even if the Samsung stock price were to fall by 50%, it would not have an appreciable impact on its KDPs.
The KRIS default probability models are benchmarked on more than two million observations of firms of all types. The total number of defaults used in the current version 6.0 models is more than 2,600. The unparalleled volume of data and the research insights of Kamakura’s Managing Director Prof. Robert Jarrow make the KRIS default probability service the most accurate early warning credit risk assessment indicator framework available. That is one of the reasons why Credit Magazine named both KRIS and the Kamakura Risk Manager Software package “Innovations of the Year”. For more information about KRIS default probabilities, please contact your Kamakura representative or e-mail Kamakura’s credit experts at info@KamakuraCo.com.