Junk my ride

Buttonwood

May 10th 2005
From The Economist Global Agenda

The downgrade of GM’s and Ford’s debt to junk status poses various problems for the bond and derivatives markets. But it has a silver lining

IT CAN now be revealed: Buttonwood no longer owns a car. With petrol costs high and congestion charges rising, car ownership for those living in central London is nine-tenths pain and one-tenth gain. So the Family Buttonwood takes public transport and rents as required.

This is an extreme form of the downsizing and switching to hybrid-energy cars that is going on in many places these days. And the shift away from its trademark gas-guzzlers is just one of the problems that have plagued Detroit of late, others being huge “legacy” costs (employee pensions and health care), the inability to come up with models that people actually like and the loss of even domestic market share to foreign-owned carmakers that can.

When General Motors and (to a lesser extent) Ford revealed their ghastly first-quarter figures last month, it confirmed that they are in crisis. The emergence on May 4th of Kirk Kerkorian, the octogenarian corporate raider who made a run at Chrysler in the 1990s, as a big buyer of GM stock perked up the carmaker’s shares with its promise of a return to more money-making ways. But Standard & Poor’s decision to downgrade the debt of GM and Ford from investment-grade to high-yield (junk) status on May 5th surprised mainly by its timing, size and inclusiveness. GM’s credit rating was reduced by two notches, Ford’s by one.

The two downgrades cover a staggering $453 billion of debt ($292 billion for GM, $161 billion for Ford). Small wonder that pundits have been pondering for a while what the impact would be of one or both of the carmakers hitting the junk-bond market at speed. Obviously it matters to GM and Ford if their cost of financing rises sharply (as it has done anyway for the past seven months or so). But will it do terrible things to the markets themselves?

Nobody really knows yet, but the answer is possibly yes—and no. The cash markets in which bonds are physically traded seem to be coping in relative style. The credit-derivatives markets, however, are showing signs of strain.

The doom-ridden scenario ran basically as follows. GM, Ford and their financing arms fall off the Lehman Brothers index of investment-grade bonds. Investors that can only hold investment-grade paper—because their agreements with clients stipulate this, or because they track the index or even just benchmark it—have to sell the fallen securities. Swamped by unaccustomed volume, high-yield prices collapse, thus hurting investors and increasing the cost to companies of raising money in this market. Meanwhile, in other credit markets hundreds of billions of dollars of credit-default swaps and collateralised debt obligations (CDOs) linked to GM and Ford begin to come unglued. Everybody hedges like mad; meltdown more or less occurs anyway.

But this isn’t what is happening. True, the spreads over Treasuries at which GM and Ford bonds trade widened sharply on the day of the downgrade. By May 10th, however, spreads had narrowed a bit. On downgrade day, the high-yield market as a whole either widened a bit or stayed still, depending on whose index is used. The prospect of vastly increased supply put downward pressure on bond prices, but less than many were expecting. Why the relative resilience?

The first reason is that investors have had plenty of time to get out of the way of this slow-moving car crash—by selling and by hedging. The second is that GM’s and Ford’s financing arms, GMAC and Ford Credit, may be able to ring-fence at least some of their lending and secure a higher credit rating for future financing. A third reason is that the bonds may not be in purdah long. It is possible that they will come off the Lehman Brothers investment-grade index at the end of May only to go back on at the end of June, when more tolerant rules for inclusion come into force. It seems to Buttonwood, however, that the chances of GM escaping without another downgrade this year are remote.

Finally, institutional investors may be less under the gun to sell than one might think. An informal poll of clients by Bank of America Securities found that fewer than 10% would have to sell GM and Ford bonds immediately if they were rated as junk, and more than half had no time constraint at all.

So much for the cash markets. There is more stress in the derivatives market. The credit-default swaps market, where protection against the possibility of default is bought and sold, is rating the “cumulative probability” that GM will default within the next five years at 63%, and the probability of Ford, GMAC and Ford Credit at between 52% and 42%. That does not mean the companies will default, but it does suggest that people take the risk seriously enough to pay for protection.

The market for CDOs, too, is feeling the strain. These are instruments which wrap together many borrowers, and the value of the CDO is determined partly by the correlation among the companies included. Growing concern about the creditworthiness of GM and Ford has shaken that correlation in many cases, which in turn has sent the value of the lowest, least secured tranche—the so-called “equity” tranche—tumbling. As a result, equity-tranche holders (many of them hedge funds) have been scrambling for cover, hedging their exposure.

It may be junk but it’s tasty

There are, believe it or not, some positive things to say about all this. For one thing, “fallen angels” (bonds downgraded from investment-grade status) often outperform bonds that are junk from the start. Edward Altman, from New York University’s Stern School of Business, is completing a study of fallen angels over the 20 years to 2003. His provisional findings are that they return more to investors than ordinary junk bonds at least for the first two years.

Furthermore, these big downgrades are a timely reminder that risk is real. It used to be said that the bond markets were “priced for perfection”. Though this has been less true since late February, when worries about America’s economy as well as its carmakers began to widen spreads, junk-bond yields are still relatively low. That may not matter too much at a time when profits are good, defaults are low and the world’s economies are still growing. But times change. Standard & Poor’s said that high-yield defaults ticked up a bit in April, for the first time in ages; more companies have been downgraded to junk so far this year (16) than were in the same period last year (11). Companies are borrowing more; leveraged buy-outs are increasing. If the carmakers’ debacle helps to cool down an overheated market, so much the better.

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