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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.

# BP PLC: A New View from the Bond Market

05/12/2014 01:08 AM

As we noted in our November 6, 2013 update on BP PLC (BP), its subsidiary BP Capital Markets PLC is one of the most heavily traded bond issuers in the domestic U.S. corporate bond market. Bonds issued by BP Capital Markets PLC have a guarantee of the parent BP PLC. For convenience, we discuss both legal entities today as if they were indistinguishable from a bondholder’s perspective. Today’s note incorporates BP Capital Markets PLC bond price data as of May 9, 2014 so that we may take an updated look at the bond market perspective on BP PLC. A total of 99 trades were reported on 19 fixed-rate non-call bond issues of BP Capital Markets PLC.

Conclusion: We believe that strong majority of sophisticated analysts would rank BP PLC as an investment grade company. The 10 year default probability outlook of BP PLC ranks in the best half of its peer group, but not by much. The bonds of BP PLC have attracted a lot of investor interest since our November 5 analysis. As a result, the bonds have been bid up to such an extent that BP Capital Markets PLC bonds now offer a credit spread to default probability ratio that has fallen from “above the median” to below the median. On May 9, 2014, 165 bond issues traded at a better credit spread to default probability ratio than the most attractive BP Capital Markets PLC bond. Investors who are interested in BP Capital Markets PLC bonds should consider other issuers until market conditions change in their favor.

The Analysis
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 BP PLC and BP Capital Markets PLC to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which states that legacy credit rating references alone are no longer sufficient to establish a security as investment grade. The Office of the Comptroller of the Currency has redefined the term investment grade as mandated by the Dodd-Frank Act.

Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority by 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. In this note, we also analyze the maturities where the credit spread/default probability ratio is highest for BP Capital Markets 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 BP 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 current default probabilities, shown in green, range from 0.04% at one month (down 0.02% from November) to 0.02% at 1 year (unchanged) and 0.15% at ten years (up 0.01% from November). The default probabilities prevailing on November 5, 2013 are shown in yellow.

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

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 19 bond issues mentioned above in this analysis.

The graph below shows 6 different yield curves that are relevant to a risk and return analysis of BP Capital Markets PLC 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 (TLT)(TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of the BP Capital Markets 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 dots graph the lowest yield reported by TRACE on that day on BP Capital Markets PLC bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day. The red dots represent the maximum yield in each BP Capital Markets PLC bond issue recorded by TRACE. The black dots and black line represent the yield consistent with a polynomial fit on a trade-weighted basis to credit spreads, explained below.

The graph shows an increasing “liquidity premium” as maturity lengthens for the bonds of BP Capital Markets PLC. This is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.

The high, low and average credit spreads at each maturity are graphed below for BP Capital Markets 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 cubic polynomial on a trade-weighted basis 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 BP Capital Markets PLC, the credit spread to default probability ratio ranges from 3.6 to 10.6 times at maturities under 2 years to a range generally between 3.5 and 7.2 times at longer maturities. These reward to risk ratios are substantially lower than we reported in November:

The same data for November 5, 2013 is shown in this table:

The credit spread to default probability ratios are shown in graphic form below for BP Capital Markets PLC in this chart.

We use the maximum smoothness approach of Adams and van Deventer (1994), as corrected in van Deventer and Imai (1996), to extract the zero coupon yields for the U.S. Treasury curve using Kamakura Risk Manager. On top of this, we fit zero coupon bond credit spreads for BP Capital Markets PLC using the same methodology and software, as we explained in the context of General Electric (GE). The results show the generally rising credit spread as maturity lengthens very clearly.

Relative Value Analysis
Are the narrowing ratios of credit spread to default probability for BP Capital Markets PLC bonds high, low, or average for the marketplace? Fortunately, there is no need to guess the answer. We load all 4,429 fixed rate corporate bond trades in the U.S. market on May 9, 2014. We extract all of those bond issues which traded at least $5 million in volume on the day with maturities of 1 year or more. We ignored ratings in this process, since we have much more accurate default probabilities. There were 281 issues in total that met these criteria. The next graph displays a histogram of the 1 year credit spread of these 281 bond issues: The median credit spread was 0.859% and the average credit spread was 1.270%. Next, we rank the 281 issues in order of the ratio of credit spread to default probability. The median credit spread to default probability ratio was 6.290 and the average was 8.561. The histogram is shown here: How did BP Capital Markets PLC bonds fare in this comparison? With 281 issues ranked, the median bond is the bond ranked 141. Two BP Capital Markets PLC bonds traded more than$5 million, but they ranked below the median at numbers 166 and 175. In other words, 165 of the 281 bond issues offered better value, as measured by the credit spread to default probability ratio, than BP Capital Markets PLC bonds.

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 2, 2014 (the most recent week for which data is available), the credit default swap trading volume on BP PLC was 25 trades for \$181 million. The weekly notional principal of credit default swap contracts traded on BP Capital Markets PLC since July 2010 is shown here:

The weekly number of credit default swap contracts traded on BP PLC is shown in the next chart:

On a cumulative basis, the default probabilities for BP PLC range from 0.02% at 1 year (unchanged from November 5) to 1.49% at 10 years (up 0.06% since November 5). The current cumulative default probabilities are shown in green and the November default probabilities are shown in yellow. BP PLC has less than one-third of the ten year cumulative default risk that we reported recently for Petroleo Brasileiro S.A.

Over the last decade, the 1 year and 5 year annualized default probabilities for BP PLC have been much more stable than the same probabilities for major financial institutions during the financial crisis, despite the damage done from the Gulf Oil spill. The 1 year default probability peaked at slightly under 0.40% in the second half of 2010. The 5 year default probability peaked at slightly under 0.25% on an annualized basis at the same time. These default probabilities are a substantial contrast from the sensationalist headlines claiming that the credit default swap market was indicating a 39% chance of a BP PLC default.

BP PLC’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 BP 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 BP PLC default risk responds to changes in 9 risk factors of the 28 selected by the Federal Reserve for its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 63.9% of the variation in the default probability of BP PLC. The remaining variation is the estimated idiosyncratic credit risk of the firm.

BP 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 “energy” sector, BP Capital Markets PLC has the following percentile ranking for its default probabilities among its 254 rated peers at these maturities:

1 month          78th percentile, unchanged from November 5
1 year             52nd percentile, down 6 from November 5
3 years           34th percentile, down 7 from November 5
5 years           45th percentile, up 1 from November 5
10 years         46th percentile, up 1 from November 5

BP PLC continues to rank near the median of its industry peer group. Taking still another view, the actual and statistically predicted BP Capital Markets PLC credit ratings both show a rating solidly 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). The legacy ratings of the company have changed only 2 times since 2003.

Conclusions
Before reaching conclusions about whether BP PLC is investment grade, we review the market’s assessment. Using a slightly different classification of the peer group, we can compare the credit spreads of BP Capital Markets PLC with the credit spreads of all firms in the energy sector whose bonds traded on May 9, 2014. The results are shown in this graph.

We find BP Capital Markets PLC credit spreads at the low end of the energy peer group. We can make the same comparison with the matched maturity default probabilities for every bond of the energy peer group that traded on May 9. The results are shown here.

The company’s default probabilities are near the middle of the energy firms whose bonds traded May 9, 2014. The next graph in this section compares the firm’s credit spreads with the traded credit spreads on November 5 of all firms with a legacy rating in the “investment grade” range.

It is clear from the graph that BP Capital Markets PLC credit spreads are on the low end of the investment grade group. In the next graph, we compare BP PLC default probabilities with the matched maturity default probabilities for all investment grade-rated firms whose bonds traded on November 5.

Again, we find that the default probabilities for BP Capital Markets PLC are on the low end of the investment grade range, indicating a stronger than average investment grade credit.

We believe that strong majority of sophisticated analysts would rank BP PLC as an investment grade company. The 10 year default probability outlook of BP PLC ranks in the best half of its peer group, but not by much. The bonds of BP PLC have attracted a lot of investor interest since our November 5 analysis. As a result, the bonds have been bid up to such an extent that BP Capital Markets PLC bonds now offer a credit spread to default probability ratio that has fallen from “above the median” to below the median. On May 9, 2014, 165 bond issues traded at a better credit spread to default probability ratio than the most attractive BP Capital Markets PLC bond. Investors who are interested in BP Capital Markets PLC bonds should consider other issuers until market conditions change in their favor.

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.