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Donald R. Van Deventer, Ph.D.

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.

Barclays Bank PLC Bonds: A Market Review

11/11/2013 05:14 AM

The Barclays PLC (BCA)(BCLYF)(BCS.D) subsidiary Barclays Bank PLC is one of the most heavily traded bond issuers in the domestic U.S. corporate bond market. Barclays PLC has had an extremely complex financial status in recent years, and the acquisition of a large part of Lehman Brothers represents just a portion of that complex history.  This complex financial history has been further aggravated by litigation expenses, past and future, involving Libor and other derivative instruments. These problems were the focus of a major feature, “Bankers,” on BBC World News on November 10.

Bonds issued by Barclays Bank PLC have been unconditionally guaranteed by The Commissioners of Her Majesty’s Treasury.  Investors should never assume that future government support is automatic if there is a history of past support. For convenience, we discuss both Barclays legal entities today as if they were indistinguishable from a bondholder’s perspective, even though most sophisticated analysts would rate Barclays Bank PLC a stronger credit than its parent, in large part because of actual past and potential future government support.

Today’s note incorporates Barclays Bank PLC bond price data as of November 8, 2013.  A total of 154 trades were reported on 27 fixed-rate non-call bond issues of Barclays Bank PLC.  Total trading volume was $73.0 million. We used all of this data in this note. 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 Barclays PLC and Barclays Bank PLC to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which requires that credit rating references be eliminated from U.S. government regulations. The complete text of the relevant regulatory rulings in this regard is given at the end of this note. Assuming the recovery rate in the event of default would be the same on all bond issues of the same credit class, 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/default probability ratio is highest for Barclays Bank PLC 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 parent Barclays PLC ranging from one month to 10 years on an annualized basis. 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 0.36% at one month to 0.14% at 1 year and 0.28% at ten years. These probabilities are the probabilities of failure of Barclays PLC. They do not reflect the possibility that, at the instant of failure, the bank is rescued. Such rescue probabilities are best estimated by the political pundits. We also explain the source and methodology for the default probabilities below. 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 27 bond issues mentioned above in this analysis. The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Barclays Bank PLC bonds. These curves reflect the noise in the TRACE data, as some of the trades are small odd-lot trades. They also reflect the noise, described above, of subordinated debt issues mixed in with senior debt issues. The lowest curve, in dark blue, is the yield to maturity on U.S. Treasury bonds (TLT)(TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of the Barclays Bank PLC. 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 Barclays Bank PLC 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 Barclays Bank PLC bond issue recorded by TRACE. The graph shows an increasing “liquidity premium” as maturity lengthens for the bonds of Barclays Bank PLC. The jump in yields near the 9 year maturity point is caused by a subordinated bond issue, the 7.625% contingent capital notes due November 23, 2022. Barclays Bank PLC has been a heavy issuer of subordinated debt relative to the typical corporate debt issuer covered in this series. This can cause the appearance of volatility when in fact the graph includes two types of debt with different recovery rates in the event of default, leading to different credit spread levels. A complete list of Barclays Bank PLC subordinated debt issues is available here. The high, low and average credit spreads at each maturity are graphed below for Barclays Bank PLC. We have done nothing to smooth the data reported by TRACE, which includes both large lot and small lot bond trades. For the reader’s convenience, we fitted a polynomial that explains the average spread as a function of years to maturity. 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 Barclays Bank PLC, the credit spread to default probability ratio ranges from 4 to 10 times at maturities under 3 years to a range generally between 4 and 8 times at longer maturities. On the long end of the credit curve, the spread to default probability ratios generally range between 5 times and 8 times. The ratios of spread to default probability for all traded bond issues are shown here: The credit spread to default probability ratios are shown in graphic form below for Barclays Bank PLC in this chart. The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended November 1, 2013 (the most recent week for which data is available), the credit default swap trading volume on Barclays Bank PLC was 191 trades for$1.33 billion. This is a very high level of trading volume indicating considerable uncertainty among market participants about the future for Barclays Bank PLC. The number of credit default swap contracts traded on Barclays Bank PLC in the 155 weeks ended June 28, 2013 is summarized in the following chart. Barclays PLC CDS volume ranked 50th among all reference names traded world-wide during this period.

The weekly trading volume for the 155 weeks ended June 28, 2013 is graphed here:

On a cumulative basis, the default probabilities for Barclays PLC range from 0.14% at 1 year to 2.76% at 10 years. Barclays PLC has ten year cumulative default risk that is roughly similar to what we reported recently for Petroleo Brasileiro S.A.

Over the last decade, the 1 year and 5 year annualized default probabilities for Barclays PLC show the volatility that is familiar from our other notes on the “too big to fail” banks during the credit crisis. The 1 year default probability peaked at slightly under 11% in the second half of 2009.  The 5 year annualized default probability peaked at slightly under 3% on an annualized basis at the same time.

As explained at the end of this note, the firm’s default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors.  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 Barclays PLC 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 Barclays PLC default risk responds to changes in 4 domestic U.S. risk factors and 10 international risk factors among the 40 world-wide macro factors used by Kamakura Corporation in its standard risk analysis, a broader set than the Federal Reserve used in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 85.1% of the variation in the default probability of Barclays PLC. The remaining variation is the estimated idiosyncratic credit risk of the firm.

Barclays PLC 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 “financials-banks” sector, Barclays Bank PLC has the following percentile ranking for its default probabilities among its 262 peers at these maturities:

 1 month 85th percentile 1 year 66th percentile 3 years 57th percentile 5 years 50th percentile 10 years 52nd percentile

Barclays PLC ranks in the riskier half of the peer group at all maturities except 5 years, where it falls exactly at the median default risk. Taking still another view, the actual and statistically predicted Barclays Bank PLC credit ratings both show a rating in “investment grade” territory.  The statistically predicted rating is 1 notch below than the legacy rating from firms like the Standard & Poor’s affiliate of McGraw-Hill (MHFI) and Moody’s Investors Service (MCO).  Thelegacy ratings of the company have changed 3 times since 2008. The legacy ratings reflect the explicit and implicit government support for Barclays Bank PLC and (to a lesser extent) Barclays PLC.

Using a slightly different classification of the peer group, we can compare the credit spreads of Barclays Bank PLC with the credit spreads of all firms in the “banks/financial” sector whose bonds traded on November 8.  The results are shown in this graph.

We find Barclays Bank PLC credit spreads (ignoring the subordinated 7.625% bonds) at the mid-point of the peer group.  We can make the same comparison with the matched maturity default probabilities for every bond of the banks/financial peer group that traded on November 8.  The results are shown here.

The company’s default probabilities are at the high end of the bank and financial firms whose bonds traded November 8, 2013.

Conclusions

Before reaching conclusions about whether Barclays PLC is investment grade, we review the market’s assessment.  The first graph in this section compares the firm’s credit spreads with the traded credit spreads on November 8 of all firms with a legacy rating in the “investment grade” range.

It is clear from the graph that Barclays Bank PLC credit spreads are near the mid-point of the investment grade group.  In the next graph, we compare Barclays PLC default probabilities with the matched maturity default probabilities for all investment grade-rated firms whose bonds traded on November 8.

Again, we find that the default probabilities for Barclays PLC are near the mid-point of the investment grade range.

We believe that a majority of sophisticated analysts would rank Barclays PLC as an investment grade company. This rating reflects current and expected future government support.  We believe that, without government support, the investment grade ranking of Barclays PLC would be marginal at best. We note that no candidate for President of the United States has ever won 100% of the popular vote, which is one reason why our informal assessment of the opinions of a large number of analysts never states that there is a unanimous opinion. Such a statement would be unprovable and extremely unlikely to be true in any event. The 10 year default probability outlook of Barclays PLC ranks in the riskier half of its peer group of 262 financials.  The bonds of Barclays Bank PLC trade in a 5 to 8 credit spread to default probability range with the current government guarantee. Speculation as to the future of government support for Barclays Bank PLC is a critical element in a decision about whether to buy its bonds. This is perhaps one reason why recent trading in Barclays Bank PLC credit default swaps shows such heavy volume. An announcement that government support will end as of a specific future date could have a major impact on bond values even though the currently outstanding bond issues benefit from a guarantee.  Those uncomfortable in forecasting the course of politics of the United Kingdom would be better served by other investments.

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.

Background on Default Probabilities Used

The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model 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 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. An overview of the full suite of related default probability models is available here.

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.

The Dodd-Frank Act and Related Regulations

Section 939A of the Dodd-Frank Act states the following:

“SEC. 939A. REVIEW OF RELIANCE ON RATINGS.

(a) AGENCY REVIEW.—Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review—
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(b) MODIFICATIONS REQUIRED.—Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(c) REPORT.—Upon conclusion of the review required under subsection (a), each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection (b).

The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:

“In this rulemaking, the OCC has amended the regulatory definition of ‘investment grade’ in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is ‘investment grade,’ banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution’s risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised ‘investment grade’ standard.”