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.” The same is true for producers of goods sold at retailers like J C. Penney Company, Inc. which operates its JCPenney stores through its wholly-owned subsidiary J. C. Penney Corporation, Inc. For many suppliers and investors, “investment grade” is an internal definition; for many banks and insurance companies “investment grade” is also defined by regulators. In this note we analyze the current levels and past history of default probabilities for J. C. Penney Company (JCP). JCP issues bonds through its affiliate J. C. Penney Corporation, Inc., but JCP is guarantor or co-obligor on the bonds. On August 16, J. C. Penney Corporation non-call fixed rate bonds were traded 85 times for $6.9 million in volume. We use that data in this analysis.
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. We analyze the maturities where the credit spread/default probability ratio is highest for J. C. Penney Company. 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, which requires that credit rating references be eliminated. The new rules delete references to legacy credit ratings and replace them with default probabilities as explained here.
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 J. C. Penney Company ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.48% at one month to 0.87% at 1 year and 2.27% at ten years.
We 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. TRACE data for J. C. Penney Company included 85 trades in 7 fixed-rate non-callable bonds of the firm on August 16, 2013. We used all of those trades in this note.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of J. C. Penney 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, interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of J. C. Penney Corporation. 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 (in orange) graphs the lowest yield reported by TRACE on that day on J. C. Penney Corporation bonds. The fourth line from the bottom (in green) displays the average yield reported by TRACE on the same day. The highest yield is obviously the maximum yield in each J. C. Penney Corporation issue recorded by TRACE.
The data makes it very clear that there is a stable liquidity premium built into the yields of J. C. Penney Corporation above and beyond the “default-adjusted risk free curve” (the risk-free yield curve plus the matched maturity default probabilities for the firm). The credit spreads are relatively smooth across the maturity spectrum with the exception of 2 or 3 bond issues. The credit spreads show a decline with maturity that is normally seen only in the case of highly troubled credits.
The high, low and average credit spreads at each maturity are graphed below. Credit spreads are gradually declining with the maturity of the bonds, with the exception of one bond with a maturity slightly longer than 23 years. There was only one trade in that bond on August 16, so the data point is of limited reliability.
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, issuing through J. C. Penney Corporation. At all maturities, the reward from holding the bonds of J. C. Penney Company, relative to the matched maturity default probability, is at least 11 basis points of credit spread reward for every basis point of default risk incurred for maturities under 4 years. The ratio of spread to default probability decreases with maturity, dropping to 2.67 at 23.17 years and 3.34 at 23.63 years.
The credit spread to default probability ratios are shown in graphic form here:
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended August 9, 2013 (the most recent week for which data is available), the credit default swap trading volume on J. C. Penney Company showed 392 contracts (tying the highest volume since July 2010) trading with a notional principal of $1.17 billion for the entire week, making J. C. Penney one of the most actively traded reference names. J. C. Penney Company is a fairly rare case, as the bond trading volume for most issuers is larger than their credit default swap trading volume. There were no credit default swap trades reported for J. C. Penney Corporation during the week. The next graph shows the weekly number of credit default swap contracts traded on J. C. Penney Company in the 155 weeks ended June 28, 2013. J. C. Penney Company ranked 25th of 1,144 reference names in contracts traded over this period:
The table below summarizes the key statistics of credit default swap trading in J. C. Penney Company during this three year period.
On a cumulative basis, the default probabilities for J. C. Penney Company range from 0.87% at 1 year to 20.50% at 10 years, as shown in the following graph.
Over the last decade, the 1 year and 5 year default probabilities for J. C. Penney Company have varied as shown in the following graph. The one year default probability has peaked twice at just under 1.50% and the 5 year default probability has risen strongly in the last 3 months, closing at 1.63% on August 16.
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 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.
The macro-economic factors driving the historical movements in the default probabilities of J. C. Penney Company include the following factors of those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
- Real gross domestic product
- Nominal gross domestic product
- Real disposable income
- Nominal disposable income
- 3 month U.S. Treasury bill rates
- 10 year U.S. Treasury yield
- 30 year fixed rate mortgage yield
- Dow Jones Industrials stock index
- The VIX volatility index
- Home price index
- Commercial real estate index
- 9 international macro factors
These macro factors explain 86.8% of the variation in the default probability of J. C. Penney Company.
J. C. Penney Company can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the international retailing sector, J. C. Penney Company has the following percentile ranking for its default probabilities among its 1,067 peers at these maturities:
J. C. Penney Company is in the most risky decile of the retailing sector at maturities of 1 year or less. J. C. Penney Company is in the 68th percentile or worse at longer maturities. A comparison of the legacy credit rating for J. C. Penney Company with predicted ratings indicates that the statistically predicted rating is six notches higher than the actual credit rating, but that predicted rating is not investment grade.
Looking one year ahead, J. C. Penney Company ranks among the most risky 10 percent of the retailing sector world-wide, a sector not renowned for its safety and soundness from a credit perspective. Moreover, it offers a substantially lower level of credit spread per basis point of default risk than most of the other firms analyzed in this series of notes at maturities longer than one year. While the credit spreads on J. C. Penney Company’s bonds issued through J. C. Penney Corporation are very wide in absolute terms, a sophisticated investor could easily earn a much higher ratio of credit spread to default risk by investing in the bonds of other issuers. We believe that the overwhelming majority of analysts would not classify J. C. Penney and its affiliates as “investment grade” by the Comptroller of the Currency’s definition.
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.