CORPORATE FINANCING FOCUS

Analysts say it's not a question of if, but when the bonds of General Motors and Ford Motor will slide below investment grade, probably late this year.

The once triple-A-rated US automakers are flirting with high-yield status, and the outlook is negative from the rating agencies.

"If GM and Ford, along with their financing arms, join the high-yield space, they will account for 15% of the market," says Kingman Penniman, director of research at Montpelier, Vermont-based KDP Investment Advisors, a firm that provides research and pricing services on high-yield bonds, including a daily index of the market.

While GM and Ford are two of the largest issuers of corporate debt, with a total of about $475 billion outstanding, including the bonds of their profitable financing units, they should be assimilated easily into the high-yield sector, Penniman says.

"Fallen angels are not a new phenomenon to the market, and the automakers will be considered as good credits by buyers of high-yield debt," he says.

"Of course, nobody knows where the bottom is for these bonds and how quickly they will come back," Penniman says. "But it is more of a technical rather than a fundamental issue."

With GM bonds yielding more than 500 basis points more than comparable US Treasury securities, they appear attractive to investors who can afford to hold on to them for the long term, he says.

Many institutional investors, including pension funds, however, are not allowed to invest in securities that are rated below investment grade. Some of these funds already are selling GM and Ford bonds in anticipation of another downgrade, according to Pemiiman.

"Nevertheless, a lot of investmentgrade accounts won't sell this paper, even if it is downgraded," he says. "They can pick up 250 basis points in yield compared with KDP's high-yield index."

Meanwhile, about one-third of the S participants in the high-yield market already have invested in GM debt, Penniman says.

A drop below investment grade would increase borrowing costs for Ford and GM, both of which need to invest in new models to compete with Asian producers, which are gobbling up US market share.

Toyota Motor of Japan, which makes the popular Prius hybrid model that runs on a combination of gasoline and electric power, could soon pass GM as the world's largest automaker.

Prices of the bonds of Ford and GM already have been beaten down so low, analysts say, that a downgrade to "junk" status already has been priced into the market to some extent.

The yield on GM's euro-denominated bonds rose sharply in late March after the automaker slashed its 2005 profit outlook and forecast a loss for the first quarter. The spread against US Treasury issues widened further when Standard & Poor's issued a "negative outlook" on the automaker, indicating that the next rating change was likely to be a downward move.

A downgrade wouldn't precipitate liquidity problems for GM, which holds nearly $20 billion in cash and another $10 billion in credit facilities, says Scott Sprinzen, a managing director at S&P. General Motors Acceptance Corporation, or GMAC, the automaker's financing unit, holds nearly $23 billion in cash.

GM is relatively well positioned to sustain a downgrade, Sprinzen wrote in a recent note to investors.

Ford cut its 2005 earnings forecast on April 11 and said it will not reach its profit target for 2006 because of rising gasoline prices and health-care costs. S&P responded by cutting the outlook on Ford debt, which is rated BBB-, the lowest investment grade, to negative from stable.

Breathing Room

The automakers may win a temporary reprieve from index-related selling of their bonds as a result of changes that Lehman Brothers is making in the inclusion rules for its widely followed investment-grade indexes. Beginning July 1, 2005, Fitch ratings will be used in addition to those from Moody's Investors and S&P when calculating the index quality assigned to individual securities.

Two out of the three agencies would need to rate the security investment-grade for it to be eligible for being included in Lehman s investment-grade indexes. These changes could become important if issuers are downgraded or upgraded by a single rating agency in the future.

Ford and GM are the second- and third-largest issuers of corporate debt, following General Electric, in the Lehman US Credit Index.

Analysts say it is possible that concern about the credit quality of the US automakers could spread to emerging-market debt if investors become less tolerant for risk.

Spreads between interest rates on riskier bonds and US Treasury bonds have widened suddenly in recent weeks, says Stephen Poloz, chief economist at Export Development Canada.

Spreads on Brazilian bonds, for example, widened to nearly 450 basis points in mid-April from as narrow as 370 basis points in early March. Spreads also widened for Mexican, Russian and Turkish bonds.

In contrast, Poloz says, US corporate bond spreads are still at their lowest level in eight years, just under 100 basis points.