Toyota Motor Corporation, Measuring the Cost of Brand Name Bonds With Zero Coupon Credit Spreads

Toyota Motor Credit Corporation bonds are covered by a hierarchy of support agreements, not an unconditional guarantee, ultimately backed by parent Toyota Motor Corporation. We use this bond price data to analyze the potential risk and return to bondholders and common shareholders of Toyota Motor Corporation

Conclusion: Toyota Motor Corporation, a former AAA-rated firm, has been downgraded three times in recent years. We believe that a very strong majority of sophisticated analysts would continue to rank Toyota Motor Corporation as investment grade by the 2010 Dodd-Frank Act definition. How do Toyota Motor Credit Corporation bonds rank among all other bonds by the ratio of credit spread to default probability? 297 other bond issues among 400 that traded heavily on May 7 offered a better credit spread to default probability ratio than the best of the bonds issued by Toyota Motor Credit Corporation. Like many other iconic names, if you want to buy a Toyota, you have to pay more—in the bond market, at least.

Analytical Objectives
Our first objective is answer whether or not Toyota Motor Corporation would be considered “investment grade” in light of the changed definition of investment grade mandated by the Dodd-Frank Act and recently implemented by the Office of the Comptroller of the Currency. For background on Dodd-Frank and related regulatory changes, see our December 6 analysis of Citigroup Inc. (C).

In this note we analyze the current levels and past history of default probabilities for Toyota Motor Corporation We also measure the reward, in terms of credit spread, for taking on the default risk of Toyota Motor Credit Corporation bonds.

Assuming the recovery rate in the event of default would be the same on all bond issues of the same seniority for 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. We analyze the maturities where the credit spread to default probability ratio is highest for Toyota Motor Corporation and Toyota Motor Credit 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 Toyota Motor Corporation ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.01% at one month to 0.01% at 1 year and 0.16% at ten years. In today’s analysis, we make the optimistic assumption that the default risk of Toyota Motor Credit Corporation bonds is identical to that of Toyota Motor Corporation, the parent. This assumption is not true, particularly since there is no unconditional guarantee of the bond issues of Toyota Motor Credit Corporation. We use this assumption as a first approximation and caution readers that this assumption will lead us to analysis which overstates the attractiveness of the bonds of Toyota Motor Credit Corporation.

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

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 bond data mentioned above for the 16 Toyota Motor Credit Corporation fixed rate non-call issues in this analysis.

The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Toyota Motor Credit 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 Toyota Motor Credit 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 curve from the bottom (the orange dots) graphs the lowest yield reported by TRACE on that day on Toyota Motor Credit Corporation bonds. The fourth line from the bottom (the green dots) displays the average yield reported by TRACE on the same day. The highest yield (the red dots) is obviously the maximum yield in each Toyota Motor Credit Corporation issue recorded by TRACE. For the reader’s convenience, we have added a trade volume-weighted credit spread, fitted to the average traded credit spread at each maturity. This curve is shown as black dots joined by black line segments.

The data makes it clear that there is a liquidity premium built into the yields of Toyota Motor Credit 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 generally widen with maturity, the normal pattern for a high quality credit.

The high, low and average credit spreads at each maturity are graphed below. Credit spreads are gradually increasing with the maturity of the bonds.

The zero coupon credit spreads and zero coupon bond yields for Toyota Motor Credit Corporation are shown in this graph versus zero coupon U.S. Treasury yields:

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 Toyota Motor Credit Corporation. At almost all maturities under 1.2 years, the reward from holding the bonds of Toyota Motor Credit Corporation, relative to the matched maturity default probability, is 13 to 28 basis points of credit spread reward for every basis point of default risk. The ratio of spread to default probability decreases with maturity after that, falling to a credit spread to default ratio between 2.3 and 4.4 times. These ratios are very low and yet they are typical for a major “brand name” issuer like Toyota.

The credit spread to default probability ratios are shown in graphic form here. We have again added a traded-weighted polynomial (shown in black) relating the fitted credit spread-default probability ratio to the years to maturity on the underlying bonds.

Relative Value Analysis
Is the reward to risk ratio for Toyota Motor Corporation higher than average, lower than average, or just average? Rather than guess, we simply look at the facts. The chart below shows the credit spreads for all fixed rate senior non-call debt issues which traded at least $5 million in volume on May 7, 2014 and had at least 1 year to maturity. There were exactly 400 bond issues that met our criteria. The median credit spread was 0.911% and the average credit spread was 1.120%. This histogram shows the distribution of credit spreads available in the market place.

The next graph shows the distribution of the credit spread to default probability ratios for all 400 issues. The median ratio was 7.737 and the average ratio was 10.850.

How did Toyota Motor Credit Corporation rank on May 7, 2014? There were 297 bond issues that offered a better credit spread to default ratio than the best ranked Toyota Motor Credit Corporation bond. The two Toyota Motor Credit Corporation bonds that traded at least $5 million were ranked between 298 and 308 on the “best value” rankings of these 400 bond issues. Clearly, investors are paying a premium for the Toyota brand.

CUSIPs
Many investors have requested that we provide CUSIPs as part of this chart. Redistribution of CUSIPs is currently prohibited by 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. In the meantime, CUSIPs for major issuers can be found easily with an internet such on web pages like this one from the New York Stock Exchange.

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 Toyota Motor Corporation was 2 trades with $9 million of notional principal, a small fraction of the bond trading volume. The weekly history of notional principal traded on Toyota Motor Corporation in the credit default swap market is shown here:

The next graph shows the number of credit default swaps traded on Toyota Motor Corporation over the same time period.

Additional Analysis
On a cumulative basis, the current default probabilities for Toyota Motor Corporation range from 0.01% at 1 year to 1.58% at 10 years, as shown in the following graph. The 10 year cumulative default probability for Toyota Motor Corporation is 4 times higher than we found in our recent analysis on the bonds issued by an affiliate of Berkshire Hathaway (BRK.B).

Over the last decade, the 1 year and 5 year default probabilities for Toyota Motor Corporation have varied as shown in the following graph. The one year default probability peaked at just under 1.70% in the first half of 2009 during the worst part of the Toyota recall incident. The 5 year default probability (annualized) peaked at just over 0.70%.

The macro-economic factors driving the historical movements in the default probabilities of Toyota Motor 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 Toyota Motor Corporation default risk responds to changes in 8 factors among the 28 factors listed by the Federal Reserve in its 2014 Comprehensive Capital Analysis and Review. These macro factors explain 77.9% of the variation in the default probability of Toyota Motor Corporation. The remainder of the risk is the idiosyncratic default risk of Toyota Motor Corporation.

Toyota Motor Corporation 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 “autos and components” sector, Toyota Motor Corporation has the following percentile ranking for its default probabilities among its 733 peers at these maturities:

1 month       20th percentile,
1 year          15th percentile,
3 years        13th percentile,
5 years        4th percentile,
10 years      2nd percentile

The percentile ranking for Toyota Motor Corporation at 5 and 10 years is in the safest 5 percentiles of credit risk among auto-related firms. Shorter term percentile rankings, however, are higher simply because current world-wide corporate credit conditions are at the 99^th percentile and short term default risk for many firms is very low.

The legacy credit ratings, those reported by credit rating agencies like McGraw-Hill (MHFI) unit Standard & Poor’s and Moody’s (MCO), for Toyota Motor Corporation have changed three times during the decade. A comparison of the legacy credit rating for Toyota Motor Corporation with predicted ratings indicates that the statistically predicted rating is three notches below the actual legacy credit rating. Both the actual and predicted ratings are “investment grade” by traditional credit rating standards of Moody’s Investors Service and the Standard & Poor’s affiliate of McGraw-Hill.

Conclusions
Before reaching any conclusions about investment grade status, it is useful to look at some additional market views of Toyota Motor Corporation and its peers. The following graph compares the traded credit spreads on Toyota Motor Credit Corporation with the traded credit spreads on the “autos and auto parts sector” peer group on May 7, 2014:

The credit spreads for Toyota Motor Credit Corporation were at the very bottom, the safest, of the sector peer group. We now look at the matched-maturity default probabilities for Toyota Motor Corporation versus that same peer group. Toyota Motor Corporation default probabilities are also on the safest end of the peer group.

We now compare the traded credit spreads for Toyota Motor Credit Corporation with the traded spreads for every firm with a legacy credit rating in the old-style “investment grade” range. Again, Toyota Motor Credit Corporation spreads are among the safest of the investment grade peer group.

By the matched maturity default probability criterion, comparing to investment grade firms with bond trades on May 7, Toyota Motor Corporation’s default probabilities are well below the average levels for the investment grade peer group.

While the default probabilities of Toyota Motor Corporation are very low compared to their peak in the credit crisis, the ten year cumulative default risk of the firm is four times higher than another iconic firm, Berkshire Hathaway. Toyota Motor Corporation, a former AAA-rated firm, has been downgraded three times in recent years. We believe that a very strong majority of sophisticated analysts would continue to rank Toyota Motor Corporation as investment grade by the 2010 Dodd-Frank Act definition. Regular readers of these notes know that low default probabilities, per se, are not enough to make the bonds of a given issuer “good value.” How do Toyota Motor Credit Corporation bonds rank among all other bonds by the ratio of credit spread to default probability? 297 other bond issues among 400 that traded heavily on May 7 offered a better credit spread to default probability ratio than the best of the bonds issued by Toyota Motor Credit Corporation. Like many other iconic names, if you want to buy a Toyota, you have to pay more—in the bond market, at least.

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.