The Federal Reserve will announce the results of the “DFAST” stress tests on March 5. On March 13, 2014, we pointed out the many reasons why the Federal Reserve-mandated stress testing process will be a less accurate measure of financial institutions’ risk than the market’s price on those institutions’ promise to pay a dollar in the future. The market place considers all scenarios, not just three as in the Fed’s CCAR stress tests. The market place invests cold hard cash to price various financial institutions’ promises to pay.
In the stress testing process, those who prepare the stress tests are often in a conflict of interest position, since it normally serves them best financially if the CCAR results are prepared on the sunny side of the street. In this note, we update our results from January 27, 2015 with the bond market assessments of financial services firms whose bonds were traded in the U.S. corporate bond market on Monday, March 2. Many of the firms whose bonds are traded are not subject to the stress testing process, so a bond market analysis gives us a broader and more comprehensive risk assessment. We use 5,383 trades on the bonds of 127 different legal entities in the financial services industry with underlying principal of $1.8 billion to rank those firms by riskiness. We rank the institutions by credit spread, by spread to the U.S. Dollar Cost of Funds Index, and by “best value,” which we define as the ratio of credit spread to matched maturity default probability.
Conclusion: 25 financial institutions led by Berkshire Hathaway Finance Corporation (BRK.A) (BRK.B) have a better spread to the U.S. Dollar Cost of Funds Index TM than the best of the four “too big to fail” financial institutions in the United States, which we define as the grouping including Bank of America Corporation (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC).
A Simple Ranking by Credit Spread
Financial firms made up 8 of the 20 most heavily traded bond issuers on March 2, 2015, as shown in this table:
We first rank the financial institutions by credit spread. We use the credit spreads from Kamakura Risk Information Services. The credit spread is calculated by using 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 the underlying bond. We use the traded weighted average price as reported by TRACE. 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.
The 20 bond issuers with the lowest average traded credit spreads are shown here:
American Express Centurion Bank (AXP), Manufacturers and Traders Trust Co. (MTB), Canadian Imperial Bank of Commerce (CM), U.S. Bancorp (USB), and State Street Bank and Trust (STT) lead the list. The ten bond issuers with the highest average credit spreads are listed in the chart below:
Improving the Accuracy of the Risk Ranking:
The U.S. Dollar Cost of Funds Index
The rankings above are potentially misleading in the sense that credit spreads vary by maturity, so an institution with only long term bonds outstanding will appear more risky than an institution with only short term bonds outstanding. The graph below shows how the credit spreads on all heavily traded bonds varied by maturity on March 2, 2015:
On average, credit spreads widen until the years to maturity hits about 18 years. The best way to correct for this potential error is to measure the premium to a credit spread index which varies by maturity. The graph below shows the U.S. Dollar Cost of Funds IndexTM on March 2, 2015:
The U.S. Dollar Cost of Funds Index TM measures the trade-weighted cost of funds for the largest deposit-taking U.S. bank holding companies. The index is a credit spread, measured in percent and updated daily, over the matched maturity U.S. Treasury yield on the same day. The current bank holding companies used in determining the index are Bank of America Corporation (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), and Wells Fargo & Company (WFC). The index is an independent market-based alternative to the Libor-swap curve that has traditionally been used by many banks as an estimate of their marginal cost of funds. Kamakura Corporation is the calculation agent, and the underlying bond price data is provided by TRACE and the U.S. Department of the Treasury. The on the run values of the index on March 2, 2015 are given here:
We calculate the matched maturity spread to the U.S. Dollar Cost of Funds Index for all 836 bonds traded on March 2, 2015. Note that we did not consolidate legal entities from the same financial institution “family” because the counter-party credit risk can vary among these legal entities. This risk ranking is the market’s ranking of the value of each firm’s promise to pay $1 (or more) at a specific date in the future. With $1.8 billion in trading volume in aggregate behind this analysis, an analyst whose opinion differs from the ranking above should be cautious. The 50 firms with the lowest average spreads relative to the U.S. Dollar Cost of Funds Index are shown in this table:
The lowest average spreads relative to the U.S. Dollar Cost of Funds Index were for Berkshire Hathaway Finance Corporation, CME Group (CME), Northern Trust (NTRS), Berkshire Hathaway Inc., and MasterCard Inc. (MA). Twenty-five financial services firms had better credit spreads than the 4 “too big to fail” financial services firms underlying the U.S. Dollar Cost of Funds Index. Bank of America N.A. ranks 26th, Wells Fargo & Co. ranks 28 th, Wells Fargo Bank N.A. ranks 29th, JPMorgan Chase Bank N.A. ranks 39th, JPMorgan Chase & Co. ranks 41st, Citigroup Inc. ranked 52nd, and Bank of America Corporation ranked 72nd. There were no traded bonds for Citibank N.A.
The widest spreads to the U.S. Dollar Cost of Funds Index were reported on these ten issuers:
For a copy of the full ranking, please contact email@example.com.
The “Best Value” Financial Services Industry Bonds
The absolute level of financial risk in a bond is necessary but not sufficient for a sophisticated bond investor to decide whether to buy or sell a particular bond.
The reason we do this “best value” analysis is because the relationship between credit spreads and matched maturity default probabilities is not a consistent one, as one can see in this graph for all heavily traded corporate bond issues on March 2, 2015:
We use the same criterion for “best” that we have used in recent analyses of bonds issued by Bank of America (BAC), AIG (AIG), AT&T (T) and IBM (IBM). That criterion is the reward to risk ratio, calculated as the ratio of credit spread to matched-maturity default probability. The default probabilities used are described in detail in thedaily default probability analysis posted by Kamakura Corporation. Both the credit spreads and default probabilities are reported as percent figures. When we rank the best value financial services bond issues by this criterion, the 20 “best value” bond issues are the ones shown in this table:
Transatlantic Holdings Inc. is an affiliate of Alleghany (Y). Goldman Sachs (GS) dominates the ranking, and not a single bond of the too big to fail four makes the list.
Regardless of the outcome of the Federal Reserve’s stress tests on March 5, the bond market view of these firms is very critical to their success or failure.
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently illegal under 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. This article neatly summarizes which institutions have restricted availability of CUSIPs in order to maximize their profits as a monopoly supplier of the data. Thanks to FINRA, the CUSIPs have been put into the public domain for free via this FINRA-affiliated website.
Background on the Calculations
Assuming the recovery rate in the event of default would be the same on all bond issues, 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.
Maximizing the ratio of credit spread to matched-maturity default probabilities requires that default probabilities be available at a wide range of maturities. We used the default probabilities supplied by Kamakura Corporation’s KRIS default probability service, interpolated to a matched-maturity basis to the exact day of bond maturity. For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk.
Bond yields are secured from TRACE. The National Association of Securities Dealers launched the TRACE ( Trade Reporting and Compliance Engine) system 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 trade-weighted average yield reported by TRACE for each of the bond issues analyzed. We calculated the credit spread using the matched-maturity yield on U.S. Treasury bonds, interpolated from the Federal Reserve H15 statistical release for the trade date. The source of the information on the H15 release is the U.S. Department of the Treasury.
Forward-Looking Best Value Bond Selection
Today’s analysis looks back at yesterday’s trades. A forward-looking bond selection based on today’s prices at this instant is done in the same way, with slight differences in the data sources.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firms in question. We believe that other authors on SeekingAlpha, 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.