Bank of America: A Pre-Stress Test Credit Risk Report Shows Dramatic Progress

Today’s study incorporates Bank of America bond price data as of September 9, 2014 to re-analyze the potential risk and return to bondholders of Bank of America Corporation. We use 222 trades on 22 Bank of America Corporation bond issues and a trading volume of $119.5 million in today’s analysis.

Conclusion: Bank of America Corporation default probabilities have fallen significantly since our June 10, 2014 report. The 10 year cumulative default probabilities are down 1.70%, a huge improvement, versus the June 10 figures. In spite of the improvements, Bank of America still ranks in the riskier half of the diversified financials peer group. Its marginal (not average) cost of funds is 0.088% higher than its peers who make up the reference names behind U.S. Dollar Cost of Funds Index.

We believe a majority of analysts would judge the bank to be slightly above the border between investment grade and non-investment grade. The reward to risk ratio, the ratio of credit spread to default probability, on Bank of America bonds has improved since our June 10 report. Nonetheless, there were still 169 out of 240 heavily traded bonds which offered a better reward to risk ratio than Bank of America Corporation on September 9, 2014.

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 Bank of America Corporation to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010. The U.S. Office of the Comptroller of the Currency has announced its implementation of the Dodd-Frank rules in 2012. The default probabilities used are described in detail in the daily default probability analysis posted by Kamakura Corporation. The full text of the Dodd-Frank legislation as it concerns the definition of “investment grade” is summarized at the end of our analysis of Citigroup (C) bonds published December 9, 2013.

Assuming the recovery rate in the event of default would be the same on all bond issues of 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 Bank of America Corporation.

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 America Corporation 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, in green, range from 0.24% at one month (down 0.09% from June 10) to 0.12% at 1 year (down 0.09% since June 10) and 0.38% at ten years (down 0.18%). The June 10, 2014 default probabilities used in our prior study are shown in yellow.

Next, we display the default probabilities for Bank of America National Association, the principal bank subsidiary of Bank of America Corporation, relative to the term structure of default probabilities of the parent. The bank default probabilities are provided by the Kamakura Risk Information ServicesU.S. Bank Default Probability Model announced on September 9, 2014 by Kamakura Corporation. The default probabilities can vary from the parent default probabilities for a number of reasons:

• The bank default probabilities use very high quality industry-specific accounting figures from the FDIC call reports. The bank model also uses macro factors as key inputs.
• The parent default probabilities use more generic financial statement information along with macro factors and stock prices.
• The parent has a real option, which has been used by a number of financial institutions, to allow the bank subsidiary to default.
• Regulators have a real option to block dividend payments from the bank to the parent.
• Both models are subject to normal estimation uncertainty.

Bank of America N.A.’s 1 year default probability is 1.23% as of September 9, 2014.

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. Bank of America Corporation was the 4^th most heavily traded corporate bond issuer in the U.S. fixed rate bond market on September 9, with 355 trades in 59 issues for a daily volume of $122 million. We eliminated all non-senior non-call bonds and all trades of $250,000 or less from this total to get the 22 bonds used for today’s study.

The graph below shows 6 different yield “curves” that are relevant to a risk and return analysis of Bank of America Corporation 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 exactly matches the maturity of the traded bonds of Bank of America Corporation. 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 yields reported by TRACE on that day on Bank of America Corporation bonds. The green dots display the trade-weighted average yield reported by TRACE on the same day. The red dots show the maximum yield in each Bank of America Corporation issue recorded by TRACE. The black dots and connecting black line show the yield consistent with the best fitting trade-weighted credit spread explained below.

The graph shows a generally increasing “liquidity premium” as maturity lengthens for the bonds of Bank of America Corporation. We explore this premium in detail below.

The high, low, average and fitted credit spreads at each maturity are graphed below for Bank of America Corporation. 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 (in black) that explains the trade-weighted average spread as a trade-weighted 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 Bank of America Corporation, the credit spread to default probability ratio generally ranges widely from 2.8 to 7.1 times, up moderately from our June 10, 2014 analysis.

The credit spread to default probability ratios are shown in graphic form below for Bank of America Corporation. The graph shows the gentle decline in the credit spread to default probability ratio once the bond maturity exceeds about 3 years.

Relative Value Analysis
Are these reward to risk ratios “normal”? Are they above or below average? The best way to answer that question is to compare them to the credit spread to default probability ratios for all fixed rate non-call senior debt issues with trading volume of more than $5 million and a maturity of at least one year on September 9. The distribution of the credit spreads on the 240 traded bonds that met these criteria on September 9 is first plotted in this histogram:

The median credit spread for all 240 trades was 0.958%. The average credit spread was 1.237%. The next graph shows the wide dispersion of the credit spread to default probability ratios on those 240 September 9 trades:

The median credit spread to default probability ratio on those 240 trades was 11.358 and the average was 21.408. A total of 169 out of 240 large trades on September 9 had better credit spread to default probability ratios than the best ratio for any of the Bank of America Corporation bonds which traded at least $5 million in volume. This means that all of the heavily traded Bank of America Corporation bonds ranked in the bottom 29% by our “best value” criterion, the credit spread to default probability ratio. We list the credit spread to default probability ratios for bond trades over $5 million in volume for Bank of America Corporation. The Bank of America Corporation bonds ranked 170^th through 199^th of the 240 large trades on September 9.

Credit Default Swap Analysis
For the week ended September 5, 2014 (the most recent week for which data is available), the Depository Trust & Clearing Corporation reported 90 credit default swap trades with notional principal of $687 million on Bank of America Corporation. This made Bank of America Corporation the 18^th ranked reference name among the top 20 credit default swap reference names by notional principal traded during the week.

The weekly history of notional principal traded on Bank of America Corporation in the credit default swap market is shown here:

The weekly history of credit default swap trading on Bank of America Corporation, measured by the number of contracts traded, period is shown in this graph:

Additional Counter-Party Credit Risk Analysis
Yesterday, we presented a detailed comparison of the marginal cost of funding for Bank of America Corporation with the U.S. Dollar Cost of Funds Index^TM , a composite credit spread for the 4 largest deposit taking banks in the United States: Bank of America Corporation (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), and Wells Fargo & Co. (WFC). As of today, the simple average differential versus the composite U.S. Dollar Cost of Funds Index ^TM shows Bank of America Corporation bonds trading at 0.088% above the index, down from 0.134% yesterday.

Kamakura Risk Information Services uses the bond prices described above to extract the trade-weighted zero coupon bond yields for Bank of America Corporation. The yields are derived in such a way that the forward credit spreads have maximum smoothness relative to the zero coupon bond yields for the U.S. Treasury curve on September 9, 2014. See van Deventer, Imai and Mesler, Advanced Financial Risk Management , 2^nd edition, 2013 for additional details. These zero coupon credit spreads are critical to evaluating the counter-party credit risk of exposure to Bank of America Corporation and other counter-parties.

On a cumulative basis, the default probabilities for Bank of America Corporation range from 0.12% at 1 year (down 0.09% from June 10, 2014) to 3.72% at 10 years (down 1.70% from June 10, 2014). The current cumulative default probabilities, shown in green, have fallen considerably since our analysis using data from June 10 (shown in yellow).

Over the last decade, the 1 year default probabilities for Bank of America Corporation and Bank of America National Association, the principal bank subsidiary, show the huge shock posed by the credit crisis and the huge benefit of the $45 billion U.S. government capital injection. The 1 year default probability peaked at more than 20% in 2009 for the parent. The peak default probability for the bank was slightly less than 15% in late 2008.

As explained earlier in 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 Bank of America Corporation 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 America Corporation default risk responds to changes in 6 risk factors among the 28 world-wide macro factors used by the Federal Reserve in its 2014 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 63.6% of the variation in the default probability of Bank of America Corporation. The remaining variation is the estimated idiosyncratic credit risk of the firm.

Bank of America Corporation 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. “diversified financials” sector, Bank of America Corporation has the following percentile ranking for its default probabilities among its 228 peers at these maturities:

1 month 89th percentile,      down 1 percentage point since June 10, 2014
1 year 79th percentile,         down 7 percentage points
3 years 74th percentile,       down 9 percentage points
5 years 61st percentile,       down 12 percentage points
10 years 60th percentile,     down 9 percentage points

For all time horizons, Bank of America default probabilities are in the riskier half of the peer group. Taking still another view, the actual and statistically predicted Bank of America Corporation credit ratings both show a rating in the lower half of “investment grade” territory. The statistically predicted rating is 2 notches below the legacy rating, those of Moody’s (MCO) and Standard & Poor’s (MHFI). The legacy credit ratings of Bank of America Corporation have changed six times in the last decade.

Conclusions
Before reaching a final conclusion about the “investment grade” status of Bank of America Corporation, we look at more market data. First, we look at Bank of America Corporation credit spreads versus credit spreads on every bond in the “Banks/Financials” sector that traded on September 9:

Bank of America Corporation credit spreads were above the average for the peer group. We now look at the matched maturity default probabilities on those traded bonds for both Bank of America Corporation and the peer group:

Consistent with the percentile rankings above, the default probabilities for Bank of America Corporation are well above the average of the industry peer group. We note that the bonds trading heavily are generally a much better group of credits than the industry in aggregate. We now turn to the legacy “investment grade” peers. First we compare traded credit spreads on September 9, 2014:

Again, Bank of America Corporation credit spreads are above the average of the investment grade peer group range. Investment grade default probabilities on a matched maturity basis for the bonds traded on September 9 are shown in this graph:

Again the default probabilities for Bank of America Corporation rank somewhat above the median for the investment grade peer group.

Bank of America Corporation default probabilities have fallen significantly since our June 10, 2014 report. The 10 year cumulative default probabilities are down 1.70%, a huge improvement, versus the June 10 figures. In spite of the improvements, Bank of America still ranks in the riskier half of the diversified financials peer group. Its marginal (not average) cost of funds is 0.088% higher than its peers who make up the reference names behind U.S. Dollar Cost of Funds Index.

We believe a majority of analysts would judge the bank to be slightly above the border between investment grade and non-investment grade. The reward to risk ratio, the ratio of credit spread to default probability, on Bank of America bonds has improved since our June 10 report. Nonetheless, there were still 169 out of 240 heavily traded bonds which offered a better reward to risk ratio than Bank of America Corporation on September 9, 2014.

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.

Copyright ©2014 Donald van Deventer