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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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May 19

Written by: Donald van Deventer
5/19/2014 7:47 PM 

We last analyzed J. C. Penney Company, Inc. (JCP) in August, 2013. In this note, we take another look at J. C. Penney Company, Inc., which operates its JCPenney stores through its wholly-owned subsidiary J. C. Penney Corporation, Inc. In this note we analyze the current levels and past history of default probabilities for J. C. Penney Company. J. C. Penney Company, Inc. issues bonds through its affiliate J. C. Penney Corporation, Inc., but J. C. Penney Company, Inc. is guarantor or co-obligor on the bonds. On May 16, 2014, 8 J. C. Penney Corporation, Inc. non-call fixed rate bonds were traded 542 times for $73 million in volume.

One of the bonds matures in 2097, so the data provides a good basis for both a short-run and long-run analysis of the firm’s ability to pay.

Conclusion: In our August 16, 2013 note, we observed that the “overwhelming majority” of analysts would NOT rate J. C. Penney Company, Inc. or its subsidiaries as “investment grade.” The same is even truer today, because the 10 year cumulative default probabilities of the firm have risen more than 24 percentage points since August. Is there any reward to risk ratio justification for taking a position in the bonds of J. C. Penney Corporation, Inc.? In August, our view was no. Our view is even stronger today, because the credit spread to default probability ratios for J. C. Penney Corporation, Inc. bonds are substantially lower than they were in August. In our view, the only investors who should be investing in J. C. Penney Corporation, Inc. bonds are those with potential upside from the liquidation of the real estate of the firm in the event of a default.

Analytical Objectives
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 suppliers and investors, “investment grade” is an internal definition; for many banks and insurance companies “investment grade” is also defined by regulators.

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 J. C. Penney Company, Inc. We also consider whether or not a reasonable U.S. bank investor would judge the firm to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, as implemented by the U.S. Office of the Comptroller of the Currency.

For investors to whom the use of default probabilities in portfolio selection is new, we highly recommend this article on bond portfolio strategy by J. P. Morgan Asset Management.

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 (in green) for J. C. Penney Company ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.83% at one month (up 0.35% from August 16, 2013) to 2.69% at 1 year (up 1.82%) and 5.79% at ten years (up 3.52%). The increases are very substantial, from a level of risk that was already well above normal levels. The default probabilities in August are shown in yellow.

 

We explain the source and methodology for the default probabilities in each Instablog posted on www.SeekingAlpha.com by Kamakura Corporation.

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. TRACE data for J. C. Penney Corporation, Inc. bonds included 542 trades in 8 fixed-rate non-callable bonds of the firm on May16, 2014. We used all of those trades in this note.

The graph below shows 6 different yield curves that are relevant to a risk and return analysis of J. C. Penney Corporation, Inc. 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 J. C. Penney Corporation, Inc. 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 line from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on J. C. Penney Corporation, Inc. 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 J. C. Penney Corporation issue recorded by TRACE. The black dots and connecting black line denote the yields consistent with a trade-weighted credit spread polynomial fit to the trade-weighted average credit spread for each bond.

The data makes it very clear that there is a minimal, if not negative, liquidity premium built into the yield on J. C. Penney Corporation, Inc. bonds above and beyond the “default-adjusted risk free curve” (the risk-free yield curve plus the matched maturity default probabilities for the firm). The liquidity premium is very close to zero for maturities of 20 to 83 years. Note that one J. C. Penney Corporation, Inc. bond issue matures in 2097. 



The high, low and average credit spreads at each maturity are graphed below, along with the trade-weighted credit spread explained above. Credit spreads are highest in the short run, which is common for firms in a very high degree of distress. 



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 J. C. Penney Company, Inc. issuing through J. C. Penney Corporation, Inc. We assume that the 10 year default probability is a good proxy for longer maturity default probabilities. We also hold U.S. Treasury yields constant for maturities longer than 30 years. At all maturities, the reward from holding the bonds of J. C. Penney Corporation, Inc. relative to the matched maturity default probability ranges from 0.872 to 2.59. This is a very sharp decline in the reward to risk ratio since our August 16, 2013 analysis. 



The ratios for August 16, 2013 are shown in this chart: 



The May 16, 2014 credit spread to default probability ratios are shown in graphic form here:



Zero coupon credit spreads versus the U.S. Treasury curve very clinically dissect the market’s perception of the value of the company’s promise to pay $1 at any date in the future. The chart shows very high initial credit spreads, followed by a narrowing at intermediate maturities and a rise thereafter.



Relative Value Analysis
Is the reward to risk ratio for J. C. Penney Corporation, Inc. bonds normal, higher than average, or lower than average? This is an important question for a very high risk instrument, since it is very common for high risk investments to be overpriced by those who love to gamble. The prototypical example is a lottery ticket, whose expected pay-off is a small fraction of the cost of the ticker. The histogram of credit spreads is shown first. These are the credit spreads on all of the fixed rate non-call senior debt issues with a maturity of 1 year or more and a trading volume of at least $5 million. On May 16, 2014, there were 322 such trades. 



The median credit spread was 0.796%, and the average was 1.268%. Next, we show a histogram of the ratio of the credit spread to default probability for all 322 issues. The median ratio was 8.378 and the average was 12.479.



Of the 322 bond issues which traded heavily on May 16, 2014, 264 offered a better reward to risk ratio than the best J. C. Penney Corporation, Inc. bond. The J. C. Penney Corporation, Inc. bonds ranked in the worst 20% of all bonds by the credit spread to default probability “best value” measure.



CUSIPs
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 J. C. Penney Company, Inc. showed 283 contracts trading with a notional principal of $1.67 billion for the entire week. The next graph shows the notional principal of credit default swap contracts traded on J. C. Penney Company, Inc. since DTCC began reporting weekly figures in July, 2010:



The graph below summarizes the number of contracts traded on the J. C. Penney Company, Inc. over the same time period. 



Additional Analysis
On a cumulative basis, the default probabilities for J. C. Penney Company, Inc. range from 2.69% at 1 year to 44.90% at 10 years, up more than 24 percentage points as shown in the following graph. The current cumulative default probabilities are shown in green, and the prior default probabilities for August 16, 2013 are shown in yellow. 



Over the last decade, the 1 year and 5 year default probabilities for J. C. Penney Company, Inc. have varied as shown in the following graph. The one year default probability has peaked at just over 6.00% and the 5 year default probability has risen strongly in recent months, exceeding 8.00% early in 2014.



The macro-economic factors driving the historical movements in the default probabilities of J. C. Penney Company, Inc. include 11 factors of the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These factors explain 73.1% of the movements in the J. C. Penney Company, Inc. default probability. The remaining variability represents the idiosyncratic risk of the firm.

J. C. Penney Company, Inc. can be compared with its peers in the same industry sector, as defined by Morgan Stanley (MS) and reported by Compustat. For the U.S.A. retailing sector, J. C. Penney Company, Inc. has the following percentile ranking for its default probabilities among its 195 peers at these maturities: 

1 month 93rd      percentile
1 year 94th           percentile
3 years 96th        percentile
5 years 94th         percentile
10 years 89th       percentile

J. C. Penney Company, Inc. is in the most risky decile of the retailing sector at maturities of 5 years or less. This is the worst percentile ranking of any firm we have analyzed so far in this series of notes.

The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO), for J. C. Penney Company, Inc. have changed eight times during the decade, a relatively high frequency for rating agencies whose median time since last rating change was 815 days in a recent study by Kamakura Corporation. A comparison of the legacy credit rating for J. C. Penney Company, Inc. with predicted ratings indicates that the statistically predicted rating is one notch higher than the actual credit rating, but that predicted rating is not investment grade.

Conclusions
While it is a temptation to jump to conclusions, we analyze one last bit of information between making our judgments on value and investment grade status. The first graph compares the credit spreads for J. C. Penney Corporation, Inc. bonds with the retailing peer group whose bonds traded on May 16, 2014. 

 

J. C. Penney Corporation, Inc. credit spreads were among the riskiest of the entire peer group. The next chart makes the same comparison on the matched-maturity default probabilities for the company versus the peer group: 

 

Again, J. C. Penney Corporation, Inc. bonds are the riskiest in the peer group at most maturities. We now turn to the credit spreads on those firms who traded on May 16, 2014 and had a legacy credit rating in that falls in the ratings-defined “investment grade” range. 



Again, J. C. Penney Corporation, Inc. bonds are at the riskiest end of the “investment grade” peer group. Not surprisingly, the same result obtains when we plot the firm versus the default probabilities of legacy “investment grade” peer firms whose bonds traded on May 16.



In our August 16, 2013 note, we observed that the “overwhelming majority” of analysts would NOT rate J. C. Penney Company, Inc. or its subsidiaries as “investment grade.” The same is even truer today, because the 10 year cumulative default probabilities of the firm have risen more than 24 percentage points since August.

Is there any reward to risk ratio justification for taking a position in the bonds of J. C. Penney Corporation, Inc.? In August, our view was no. Our view is even stronger today, because the credit spread to default probability ratios for J. C. Penney Corporation, Inc. bonds are substantially lower than they were in August. In our view, the only investors who should be investing in J. C. Penney Corporation, Inc. bonds are those with potential upside from the liquidation of the real estate of the firm in the event of a default.

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 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.

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