Vehicular Bond Slaughter

By Eric J. Fry

Now that GM’s credit rating clings for its life, millions
of bond investors are holding a candle for the auto titan –
hoping for a miraculous recovery.

If GM’s investment-grade rating sheds its mortal coil, the
entire corporate bond market may suffer a near-death
experience, especially that portion of the bond market that
already faces life and death situations every day…the
junk-bond sector.

Now more than ever, therefore, junk bonds – known in polite
company as "high-yield" bonds – might not be suitable for
widows and orphans…or for married couples and their
children…or for divorcees…or for same-sex partners…or
for almost any other sort of investor who favors return OF
capital over return ON capital.

Last week, an intellectually honest credit analyst at
Standard & Poor’s named Scott Sprinzen, plunged the credit
ratings of both General Motors and Ford into the ranks of
junk borrowers. In so doing, he seemed to plunge many junk-
bond investors into a state of extreme denial.

To be sure, many GM bondholders panicked immediately upon
learning of the downgrade and dumped their holdings.
Likewise, many other high-yield investors reacted swiftly
and decisively to the news by dumping an array of high-
yield bonds.

A few steps removed from the fray, however, the owners of
closed-end funds that invest in high-yield securities
steadfastly held their ground. They responded as if GM’s
travails posed no risk whatsoever to the rest of the high-
yield market.

RMK High Income Fund (NYSE: RMH), for example, continues to
hold near its recent highs, even though GMs bonds are
plummeting toward all-time lows. Are RMH shareholders
courageous or naïve? (Or maybe they’re courageous AND
naïve). Let the reader decide.

We would readily concede that GM bonds and the rest of the
high-yield market are not one and the same. But neither are
they as different as RMH’s resilient share price would seem
to imply.

The chart below presents the recent yield histories of a GM
bond maturing in 2015 and an index of BB-rated bonds (GM’s
new peer group). A close correlation between the two is
readily apparent, as is the recent spike in GM’s yield to
distressed levels.

If GM’s bonds – the newest and largest members of the junk-
bond ranks – are reflecting extreme distress, shouldn’t the
prices of closed-end funds that specialize in junk bonds be
reflecting at least mild concern? A few of them are, but
many are not.

Last week’s twin-downgrade of Ford and GM was not an every-
day event. To the contrary, both automakers are massive
borrowers. "GM, with about $300 billion in notes, bonds,
loans and asset-backed securities as of Dec. 31, and Ford,
with about $151 billion, are the biggest companies [ever]
cut to junk," Bloomberg News reports. "The former biggest
so-called fallen angel was WorldCom, which had $30 billion
of bonds cut to speculative grade on May 10, 2002. GM’s cut
affects about $200 billion of debt."

For perspective, GM’s debt alone would account for about
15% of all U.S. high-yield bonds outstanding. In other
words, junk-bond buyers might find themselves with much
more junk than they wish to buy. And a dollar spent buying
a bond issued by GM or Ford bonds would be a dollar NOT
spent buying some other sort of junk bond. Net-net, we
suspect GM and Ford will be about as welcome in the junk-
bond market as a windstorm at an origami festival…and
just as disruptive.

"When Standard & Poor’s shunted General Motors and Ford
into the credit junkyard on Thursday," the Times of London
remarked, "there was no groan of bending steel, no screech
of torn metal."

Very true. But a car that is hurtling off a cliff makes no
sound whatsoever…for a while.

"The cliffhanger is whether another ratings agency, such as
Moody’s or Fitch, follows S&P’s lead," the Times continues.
Such a decision would push GM out of Lehman’s Global
Aggregate index and into the world of fixed-income
"untouchables." Many pension funds and other institutional
investors may not own junk-rated bonds. If/As/When these
institutional investors must disgorge their GM and Ford
bonds, traditional high-yield investors might choke on the
supply.

As for the prospect of a meaningful financial recovery at
GM, we are dubious. Nothing short of the miraculous will
enable GM to recover any semblance of its past glory. The
automaker’s share of the U.S. auto market during the first
four months of the year tumbled to an 80-year low of 25.6
percent – down from 27.3 percent in the same period of
2004.

"Although GM has substantial cash reserves," Sprinzen
ominously concludes, "its ability to withstand persistent
poor financial performance is not unlimited."

Maybe the worst is over already for the high-yield market,
but we doubt it. And even if we wanted to believe it, we
would not bet on that outcome with any of our own money.
Hold a candle for GM’s credit rating if you wish, but don’t
hold your breath.

Did You Notice…?
By Eric J. Fry

"Bond yields in all major countries are falling toward all-
time lows," bond-fund guru Bill Gross observed last Friday.
"So it looks like these bond markets are telling us that
the global economy is slowing down."

Who are we to disagree?

The bond markets must also be telling us that inflation is
less of a problem than many of us had feared. The bond
market might change its mind, of course. But it has been
holding the identical opinion for several months now…

Eventually, we might be forced to hold the same opinion.

And the Markets…