Bank of Nova Scotia (BNS), founded in 1832, is the third largest bank in Canada. Investors in North American financial institutions seem overly-focused on names like Bank of America (BAC), which has 20 times the retail following than Bank of Nova Scotia. That disparity often spells opportunity, so we ask the question, “What is the current bond market view of Bank of Nova Scotia?” Today’s study incorporates 40 May 14 bond trades on 11 U.S. dollar bonds issued by Bank of Nova Scotia with trading volume of $55.9 million. We use this bond price data to analyze the potential risk and return to bondholders and common shareholders of Bank of Nova Scotia.
Conclusion: Bank of Nova Scotia is a sterling investment grade credit by the modern definition of the term “investment grade.” The surprise with Bank of Nova Scotia is the extraordinarily good reward to risk ratios on its bonds. Only 6 of 439 bond issues traded on May 14 offered a better credit spread to default probability ratio than Bank of Nova Scotia. Indeed, when looking at Bank of Nova Scotia bonds, one question comes to mind: Why does anyone buy U.S. Treasuries when BNS bonds are available?
Our first objective is answer whether or not Bank of Nova Scotia 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 Office of the Comptroller of the Currency. For background on Dodd-Frank and related regulatory changes, see our December 6 analysis of Citigroup Inc. (C).
In this note we analyze the current levels and past history of default probabilities for Bank of Nova Scotia. We also measure the reward, in terms of credit spread, for taking on the default risk of Bank of Nova Scotia 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 Bank of Nova Scotia.
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 Bank of Nova Scotia ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.00% at one month (note that the default probability is positive but rounding makes it zero) to 0.02% at 5 years and 0.04% at ten years. These are among the lowest default probabilities of any bond issuer covered in this series of notes.
We explain the source and methodology for the default probabilities in each Instablog posted by Kamakura Corporation on SeekingAlpha.
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 the bond data mentioned above for the 11 Bank of Nova Scotia fixed rate non-call issues in this analysis.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Bank of Nova Scotia 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 Bank of Nova Scotia. 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 Bank of Nova Scotia 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 Bank of Nova Scotia 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 Bank of Nova Scotia above and beyond the “default-adjusted risk free curve” (the risk-free yield curve plus the matched maturity default probabilities for the firm). In fact, the default risk of the firm is barely discernible on this graph.
The high, low and average credit spreads at each maturity are graphed below.
The zero coupon credit spreads and zero coupon bond yields for Bank of Nova Scotia are shown in this graph versus zero coupon U.S. Treasury yields. We showed in a recent note on General Electric Company (GE) how we can restate the dividend yield on a credit-adjusted basis. Clearly that adjustment, due to credit risk, would be only slightly lower than the traditional dividend yield for Bank of Nova Scotia because of the narrow credit spreads one can see in this graph:
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 Bank of Nova Scotia At maturities under 1.5 years, the reward from holding the bonds of Bank of Nova Scotia, relative to the matched maturity default probability, is 48 to 461 basis points of credit spread reward for every basis point of default risk. These are very high ratios of reward to risk. The ratio of spread to default probability decreases with maturity after that, falling to a credit spread to default ratio between 11 and 34 times. These ratios are very high also, and it will be interesting to look at the peer comparison to see how they rank.
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 Bank of Nova Scotia 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 which traded at least $5 million in volume on May 14, 2014 and had at least 1 year to maturity. There were 439 bond issues that met our criteria. The median credit spread was 0.91% and the average credit spread was 1.19%. 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 439 issues. The median ratio was 7.07 and the average ratio was 10.28.
How did Bank of Nova Scotia rank on May 14, 2014? There were only 6 bond issues that offered a better credit spread to default ratio than the best ranked Bank of Nova Scotia bond. The three Bank of Nova Scotia bonds that traded at least $5 million were ranked between 7 and 32 on the “best value” rankings of these 439 bond issues. Bank of Nova Scotia clearly is in the top 10% 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 such 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 9, 2014 (the most recent week for which data is available), the credit default swap trading volume on Bank of Nova Scotia was literally zero. Weekly data from the DTCC from July 2010 onward confirms that there has never been a single credit default swap trade on Bank of Nova Scotia, in spite of its stature as one of the largest banks in North America.
On a cumulative basis, the current default probabilities for Bank of Nova Scotia range from 0.00% at 1 year (the zero is again caused by rounding) to 0.36% at 10 years, as shown in the following graph. The 10 year cumulative default probability for Bank of Nova Scotia is one of the lowest we have seen in this series of notes on bond market perspectives.
Over the last decade, the 1 year and 5 year default probabilities for Bank of Nova Scotia have varied as shown in the following graph. The one year default probability peaked at just over 0.14% in the first half of 2009 during the worst part of the credit crisis. The 5 year default probability (annualized) peaked at just over 0.10%. This is an extraordinary performance during a turbulent period.
The macro-economic factors driving the historical movements in the default probabilities of Bank of Nova Scotia 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 Bank of Nova Scotia default risk responds to changes in 9 factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 78.2% of the variation in the default probability of Bank of Nova Scotia. The remainder of the risk is the idiosyncratic default risk of Bank of Nova Scotia
Bank of Nova Scotia can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the world-wide “banks” sector, Bank of Nova Scotia has the following percentile ranking for its default probabilities among its 1,338 peers at these maturities:
1 month 0th percentile, tied for lowest
1 year 0th percentile, tied for lowest
3 years 1st percentile, 13th lowest
5 years 1st percentile, 10th lowest
10 years 1st percentile, 10th lowest
The percentile ranking for Bank of Nova Scotia is among the very best of all the firms on which we have reported.
The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO), for Bank of Nova Scotia have changed only once since 2006. A comparison of the legacy credit rating for Bank of Nova Scotia with predicted ratings indicates that the statistically predicted rating is one notch 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 Bank of Nova Scotia and its peers. The following graph compares the traded credit spreads on Bank of Nova Scotia with the traded credit spreads on the “Banks/Finance” peer group on May 14, 2014:
The credit spreads for Bank of Nova Scotia were near the very lowest spreads in the peer group. We now look at the matched-maturity default probabilities for Bank of Nova Scotia versus that same peer group. Bank of Nova Scotia default probabilities are also on the very low end of 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 Bank of Nova Scotia with the traded spreads for every firm with a legacy credit rating in the old-style “investment grade” range. Again, Bank of Nova Scotia spreads are far below the median and near the lowest spreads observed among investment grade firms.
By the matched maturity default probability criterion, comparing to investment grade firms with bond trades on May 14, Bank of Nova Scotia’s default probabilities are very far below the median of the investment grade peer group.
With this data in mind, we draw some dispassionate conclusions. Bank of Nova Scotia is a sterling investment grade credit by the modern definition of the term “investment grade.” We believe that it would be very hard to find a serious analyst who would disagree with that conclusion. The surprise with Bank of Nova Scotia is the extraordinarily good reward to risk ratios on its bonds. Only 6 of 439 bond issues traded on May 14 offered a better credit spread to default probability ratio than Bank of Nova Scotia. Indeed, when looking at Bank of Nova Scotia bonds, one question comes to mind: Why does anyone buy U.S. Treasuries when BNS bonds are available?
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 SeekingAlpha, 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.