Petroleo Brasileiro S.A.: A Gloomy Bond Market Update

In this note, we turn to the U.S. dollar bonds issued by Petroleo Brasileiro S.A. affiliatePetrobras International Finance Co., which is guaranteed by the parent. Later in the post we include a relative value analysis of another affiliate, Petrobras Global Finance B.V., which is also guaranteed by the parent.

We seek to bring a bond market perspective to the outlook for Petroleo Brasileiro S.A. as a complement to analysis based on a common stock holder’s perspective. Today’s note incorporates Petroleo Brasileiro S.A. bond price data as of April 29, 2014. A total of 279 trades were reported on 12 fixed-rate non-call senior bond issues of Petrobras International Finance Co. Total trading volume was $142 million. We used all of this data in this note.

Conclusion: We believe that sophisticated analysts would narrowly rank Petroleo Brasileiro S.A. as a non-investment grade company. The legacy rating agencies are notorious for their positive bias with respect to large firms and for their lagged response to changing circumstances. The 10 year default probability outlook of Petroleo Brasileiro S.A. ranks in the worst half of its peer group, and the percentile ranking has dropped substantially in the last 6 months. The bonds of Petrobras Brasileiro S.A. trade at a below average credit spread to default probability ratio. We believe that the market-based peer group comparisons correctly show that Petroleo Brasileiro S. A. is risky compared to its peers and that only investors with a large risk appetite are likely to feel comfortable with this name in their portfolio.

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 Petroleo Brasileiro S.A. to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which states that legacy credit ratings alone are no longer sufficient to establish that a bond issuer is “investment grade.Assuming the recovery rate in the event of default would be the same on all bond issues by the same issuer for the same seniority, 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 Petroleo Brasileiro S.A.

Term Structure of Default Probabilities
Maximizing the ratio of credit spread to matched-maturity default robabilities requires that default probabilities be available at a wide range of maturities. The graph below shows the current default probabilities for Petroleo Brasileiro S.A. 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 0.74% at one month (up 0.13% from October, 2013) to 0.44% at 1 year (up 0.12%) and 0.55% at ten years (up 0.16%). The default probabilities prevailing on October 29, 2013 are shown in orange.

We also explain the source and methodology for the default probabilities inInstablogs posted daily 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 12 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 Petroleo Brasileiro S.A. 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 Petroleo Brasileiro S.A. 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 Petroleo Brasileiro S.A. 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 Petroleo Brasileiro S.A. bond issue recorded by TRACE. The black dots and connecting black line show the yield curve that would prevail if a cubic polynomial is fitted to the trade-weighted credit spreads for Petroleo Brasileiro S.A.

The graph shows an increasing “liquidity premium” as maturity lengthens for the bonds of Petroleo Brasileiro S.A. This is a pattern seen usually with firms of average to good credit quality. We explore this premium in detail below.

The high, low and average credit spreads at each maturity are graphed below for Petroleo Brasileiro S.A., along with the fitted credit spreads in black. We have done nothing to smooth the data reported by TRACE, which includes both large lot and small lot bond trades.

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 Petroleo Brasileiro S.A., the credit spread to default probability ratio ranges from 2.2 to 4.7 times at maturities under 3 years to a range generally between 4.8 and 5.9 times at longer maturities. These ratios are substantially lower than those found on October 29, 2013. The ratios of spread to default probability for all traded bond issues are shown here:

The data from October 29, 2013 is reproduced in this chart:

The credit spread to default probability ratios are shown in graphic form below for Petroleo Brasileiro S.A. in this chart.

Using the bond data above, we can extract the continuously compounded yield on a promise by the company to pay $1 at any date in the future. As the graph shows, these yields are substantially higher than a similar promise by the U.S. government. We do not mean to imply that a promise by the U.S. government (or any other government) will be kept. That is the subject of other notes in this series.

Relative Value Analysis
Are the credit spread to default probability ratios for Petroleo Brasileiro S.A. good, bad, or average? The only sophisticated answer to that question is based on hard facts from the current bond market. For that reason, we first look at a histogram for all bond issues which traded on April 29, 2014 in volume of more than $5 million with maturities of more than 1 year. There were 408 issues in total that met these criteria, and their credit spreads are plotted here:

The median credit spread on these 408 issues was 0.868%, and the average was 1.131%. How about the ratio of credit spread to default probability for all 408 issues? That is shown in the following histogram. The median ratio was 7.204 and the average ratio was 10.813.

How did Petroleo Brasileiro S.A. compare to these 408 peer group issues traded on April 29, 2014? The answer is that 231 of the 408 issues traded at better credit spread to default probability ratios than any bond of any legal entity affiliated with Petroleo Brasileiro S.A. For the reader’s convenience, we include bonds issued by Petrobras Global Finance B.V. in the chart. The Petrobras-affiliated legal entities ranked from 232 to 300 of the 408 bond issues, that is, solidly in the third quartile of all the bonds that traded at least $5 million on April 29, 2014.

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 April 25, 2014 (the most recent week for which data is available), the credit default swap trading volume on Petroleo Brasileiro S.A. was 3 trades for only $700,000. That figure is not a typo. The notional principal and the number of credit default swap contracts traded on Petroleo Brasileiro S.A. since the Depository Trust & Clearing Corporation began releasing weekly statistics will be shown in a companion post on SeekingAlpha.com.

Additional Analysis
On a cumulative basis, the default probabilities for Petroleo Brasileiro S.A. range from 0.44% at 1 year (up 0.12% from October 29, 2013) to 5.41% at 10 years (up 1.59% since October 29, 2013). This is a substantial increase in cumulative default risk.

Over the last decade, the 1 year and 5 year annualized default probabilities for Petroleo Brasileiro S.A. have been much more stable than the same probabilities for major financial institutions during the financial crisis. The 1 year default probability peaked at slightly under 1.80% in early 2009. The 5 year default probability peaked at slightly under 0.60% on an annualized basis at the same time. That being said, default probabilities are in a steadily rising trend that cannot be ignored. The current 5 year default probabilities are near their 2009 peak.

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 Petroleo Brasileiro S.A. 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 Petroleo Brasileiro S.A. default risk responds to changes in 8 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 59.6% of the variation in the default probability of Petroleo Brasileiro S.A. The remaining 40.4% of total variation is the estimated idiosyncratic credit risk of the firm.

Petroleo Brasileiro S.A. 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, Petroleo Brasileiro S.A. has the following percentile ranking for its default probabilities among its 1,772 peers at these maturities:

1 month 90^th percentile,     up 4 points since October
1 year 79^th percentile,        up 6 points
3 years 72^nd percentile,      up 7 points
5 years 59^th percentile,       up 8 points
10 years 51^st percentile,     up 9 points

The percentile ranking of Petroleo Brasiliero S.A. has deteriorated significantly since October, 2013. Over a longer time horizon, Petroleo Brasileiro S.A. ranks in the riskier half of its peer group from a credit risk.

Taking still another view, the actual and statistically predicted Petroleo Brasileiro S.A. credit ratings both show a rating in the very low end of the “investment grade” territory. The statistically predicted rating is 2 notches higher 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 4 times since January, 2007. Both the legacy rating and the statistically predicted legacy rating reflect the fact that rating agency ratings are biased high for large companies. Put simply, Petroleo Brasileiro S.A. is over-rated because it is big. The bond market recognizes this.

Conclusions
Before reaching conclusions about whether Petroleo Brasileiro S.A. is investment grade, we review the market’s assessment.

Using a different classification of the peer group, we can compare the credit spreads of Petroleo Brasileiro S.A. with the credit spreads of all firms in the “Latin American corporate sector” whose bonds traded on April 29. The results are shown in this graph.

We find Petroleo Brasileiro S.A. credit spreads at the very high end of the Latin American peer group. We can make the same comparison with the matched maturity default probabilities for every bond of the peer group that traded on April 29. The results are shown here.

The company’s default probabilities are on the high end of the Latin American firms whose bonds traded April 29, 2014.

The next graph compares the firm’s credit spreads with the traded credit spreads on April 29 of all firms with a legacy rating in the “investment grade” range.

It is clear from the graph that Petroleo Brasileiro S.A. credit spreads are on the very high end of the investment grade group. In the next graph, we compare Petroleo Brasileiro S.A. default probabilities with the matched maturity default probabilities for all investment grade-rated firms whose bonds traded on April 29.

Again, we find that the default probabilities for Petroleo Brasileiro S.A. are on the very high end of the investment grade range.

We believe that sophisticated analysts would narrowly rank Petroleo Brasileiro S.A. as a non-investment grade company. The legacy rating agencies are notorious for their positive bias with respect to large firms and for their lagged response to changing circumstances. The 10 year default probability outlook of Petroleo Brasileiro S.A. ranks in the worst half of its peer group, and the percentile ranking has dropped substantially in the last 6 months. The bonds of Petrobras Brasileiro S.A. trade at a below average credit spread to default probability ratio.

This weak premium is in part determined by the fact that the legacy credit rating agencies still rank the firm as “investment grade.” While the link between ratings and credit spreads is very weak (ratings explain only 28% of credit spread movements), a downgrade of the firm’s bonds would have a significant negative impact on bond prices. We believe that the market-based peer group comparisons correctly show that Petroleo Brasileiro S. A. is risky compared to its peers and that only investors with a large risk appetite are likely to feel comfortable with this name in their portfolio.

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.