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DEBT REPORT: US BOND ISSUES 52 applied for court protection from its creditors under the US Chapter 11 bankruptcy code of practice. Dramatic as the investor reaction was, there is little risk that GM or Ford will have to contemplate this course – at least in the near to medium term. While most analysts believe that further downgrades are eminently possible (S&P has put both companies' ratings on negative watch) they still have large cash positions and substantial undrawn bank facilities.“The companies have a lot of liquidity and that is a source of hope,” maintains Scott Sprinzen, the S&P analyst in New York who covers the industry. “In the auto sector there have been examples of dramatic turnarounds.” Sprinzen adds that the big cash holdings combined with relatively light profiles of maturing debt make it unlikely that either company could seek Chapter 11 protection in the next two years.“You have to be able to demonstrate that you’re insolvent, and that’s hard to do when you are sitting on a lot of cash,”he points out. While the senior unsecured bond markets are probably closed to both companies for the foreseeable future, they can still raise further liquidity if required by selling more asset-backed securities. Almost all their main asset types (retail loans, wholesale loans, retail leases) are securitisable. Alternately, they can unload loan portfolios to third parties in the whole-loan markets. Nevertheless, the loss of investment grade status for two motor titans will have widespread ramifications for the corporate – and other – bond markets. It has already led to the downgrading of several collateralised debt obligations (CDOs) in which Ford and/or GM bonds formed part of the collateral. Following a review of 561 European synthetic CDOs, S&P said 19 of the 745 classes required downgrading and a further 25 needed to be placed on negative watch. While much of the reaction to date has focused on the CDO market – much of it down to hedge funds that misread arbitrage opportunities in the derivatives of the equity and mezzanine tranches covering positions – investment grade portfolio managers may well have to offload tens of billions of dollars' worth of the auto makers' bonds in the coming weeks. The picture is clouded, however, by the impending change in Lehman Brothers' US Aggregate Bond Index, the most widely used US measure for tracking investment grade credits. From July 1, the index will use the middle rating from the top three agencies (S&P, Moody’s and Fitch) rather than the lower of S&P's or Moody's as it does at present. Provided Moody’s and Fitch do not downgrade the companies to sub-investment grade in the meantime, their bonds could become eligible holdings again in a few US Auto Sector measures impact of new junk bond status 120 110 100 90 80 70 31-Dec-03 31-Jan-04 29-Feb-04 31-Mar-04 30-Apr-04 31-May-04 30-Jun-04 31-Jul-04 31-Aug-04 30-Sep-04 31-Oct-04 30-Nov-04 Ford Mtr Cr Co Cont Offer Bd Mtnf 7.100 09/20/13 31-Dec-04 31-Jan-05 29-Feb-05 31-Mar-05 30-Apr-05 31-May-05 General Mtrs Corp Deb 8.375 07/15/33 Data as at June 05. Source: FTSE Group. weeks. A lot of investors holding GM and Ford bonds are consequently expected to sit tight.“That means the process of shifting Ford and GM [stock] is not going to happen in one go,”says the deputy head of credit strategy at one of the leading Continental European banks in London. “Personally, I think it is going to be relatively protracted.” He adds that the sell-off could have a bigger impact on the high-yield bond markets in Europe than in the US, given that the downgraded debt of GM and Ford would account for a much higher percentage – about a third – of the market on this side of the Atlantic.“I think over time the effect you see will be more pronounced in Europe,”says the banker. There is also a risk that the Ford/GM situation will blight wider corporate issuance in the US. The latest figures from the data provider Dealogic revealed a dramatic drop in new issues from speculative-grade companies in the second quarter so far – 69% down on the comparable period of 2004 – and a 7% decline in the volume from investmentgrade companies.This followed the pattern seen in the first three months of 2005, where junk bond issuance dropped 64% and investment-grade 18% on last year, but in part reflects stronger cash positions after seven quarters of continuous profits growth. There was also evidence that investor confidence in the senior unsecured sector was starting to ebb before S&P announced the Ford and GM downgrades. Spreads had certainly started to widen in March, after GM had warned that its profits for 2005 were likely to be 80% lower than previous forecasts. The month also saw the inflow of foreign capital into US corporate bonds dive from about US$80bn in February to US$48bn, a development that aroused the interest of foreign-exchange analysts and dealers who believe the subsequent Ford and GM downgrades can only accelerate this move. “I would have thought that that [the downgrades] is ultimately going to put pressure on those credit markets going forward,” says Richard Franulovich, senior currency strategist at Westpac Banking Corp in New York, “the next big adjustment is a further widening of spreads.” Franulovich adds that Ford and GM’s loss of investment grade status was also affecting the market for US Treasuries, with the yields on short term bills dropping as low as 3%.“It is generating a flight to quality,”he explains. The rating agencies are not forecasting a general decline in corporate access to unsecured capital market debt at this stage.“We have not really seen it show up yet,”says David Hamilton, head of default research at Moody’s Investor Services in New York.“The damage seems to be fairly well contained to pockets of distress at this point.” In its latest JULY/AUGUST 2005 • FTSE GLOBAL MARKETS
monthly default report, Moody’s for risk over the coming months. also points out that while it expects “The resilience of the market has (12-month ahead) default rates to not really been tested so far [in rise from the current 2% to 3.3% by this crisis].” He adds that buyers April 2006, this figure will still be are likely to become more below the 20-year average annual selective. “I guess they are going rate of 4.9%. to become very much more Standard & Poor’s (S&P) also discriminating towards credit, and published a positive credit outlook there will be a lot more for US corporate bonds in mid- differentiation between sectors.” April. The agency’s analysis Hatch at Madison believes that revealed that in the first quarter of the distressed debt market for 2005 the ratio of downgrades to corporate debt is consequently set total rating actions fell to 53% - for spectacular growth over the dropping well below the 18-year next three years in the aftermath of average of 62%. It attributed the the high-profile cases such as improvement to the expanding Enron, Worldcom and K-Mart, as economy (US GDP rose 4.4% in external factors and a change in 2004) which had seen the profits of corporate approach will produce a speculative-grade companies rise Diane Vazza, director of Global Fixed Income further wave of bankruptcy filings more rapidly than those of Research at Standard and Poor’s. from middle-tier companies. On investment grade ones. The S&P top of the pressures of rising outlook did caution, however, while most industries interest rates, commodity prices and increased competition seemed to be “extremely solid”a few still had problems and from foreign competitors, Hatch maintains that Chapter 11 highlighted airlines, petrochemical companies, retail and no longer carries the stigma it did a decade ago and that restaurant businesses as those most at risk. It said more some companies increasingly view it as a strategic tool to than 30% of the companies in these sectors had negative get rid of unwanted financial burdens, such as pension outlooks. Diane Vazza, managing director in global fixed- obligations, healthcare costs and expensive leases. income research at S&P in New York, adds that defaults The most recent example was United Airlines’successful among high-yield issuers will start to “tick up”as the credit court petition on May 10 to transfer US$10bn of pension quality of issuers deteriorates in what is an ageing bull liabilities from its four schemes to the Federal pension market. She points out that 50% of speculative-grade protection plan. Hatch believes the senior unsecured bonds issues this year have been rated B- or lower, with triple-C of companies that use the bankruptcy regime for these bonds carrying a 29% chance of default in their first year. purposes should offer better recovery rates. She points to “Gains from here are going to be limited,”she concludes. the experience of the “slew” of companies that entered In the high-yield market, Moody’s estimates there are Chapter 11 over the past four years to seek protection from US$56bn of high-yield corporate bonds due to mature, and asbestos claims. “The recovery rates for those bonds are which need refinancing, over the next three years. The higher than for those [companies] with an honest to figure includes US$20bn of maturing debt in the goodness reason for going into Chapter 11.” telecommunications, technology and media sector, which At the same time she cautions that overall recovery rates was the primary source of corporate defaults in 2004. in the distressed debt market are likely to plummet as Investors in US corporates also expect to see some sectors higher interest rates, fuel costs and commodity prices make to suffer more than others. Kjerstin Hatch, portfolio manager the economic environment – and refinancing – more at distressed-debt investor Madison Capital Management in difficult. “It is not going to be as easy to rely on the next New York, says those that will come under the most stress churn.” In many cases, she says companies that enter over the next three years are automotive suppliers, airlines, bankruptcy proceedings will no longer have any textile manufacturers, and some of the traditional worthwhile assets to restructure and holders – or buyers – supermarket groups. They will struggle to compete on cost of their paper will need to revise their expectations with the low-wage Wall-mart model suggests Hatch.“Your accordingly. She expects recovery rates – as a percentage of old-time supermarket stores are still operating under a bonds’par values - to drop from the current 50-70% range unionised system,”Hatch explains.“And I think we are going into the “teens and low 20s”. She believes the trend will to see more pain in the airline sector – probably Delta.” work in the favour of the more established distressed-debt Meanwhile, Matein Khalid, the capital markets specialists, as these lower returns will drive many of the strategist and chief dealer at Union National Bank in Abu relative newcomers out of the market and reduce the Dhabi who previously managed global bond portfolios at demand for such debt.“I think as money flows out, you will Chase Manhattan and First Chicago in New York, says get the over-reaction and that will give opportunities to the the difficulties in these sectors will test investor appetite experienced investors.” FTSE GLOBAL MARKETS • JULY/AUGUST 2005 53
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