The sky fell on two U.S. industrial icons on May 5, when Standard & Poor’s Ratings Services cut the bond ratings of General Motors Corp. and Ford Motor Co. to below investment grade. The greatest industrial empires of America have been relegated to the twilight zone of junk debt, in which bonds trade on the prospects for an issuers’ survival more than on interest rate trends.

GM’s 83/8% bond due 2033 recently traded at $75.375 per $100 face value, resulting in a yield to maturity of 11.34%, nearly 700 basis points above U.S. treasuries of the same term. A Ford 7.40% bond due November 2046 is priced at $68.50 to yield 10.87% to maturity, with a comparably wide spread over the government bond.

The downgrades pose a tough question for investors and advisors: Are the new yields a gift or an omen? To answer the question, it’s helpful to understand why the two auto giants are now trading at prices characteristic of doubtful junk.

Prior to the downgrade, much of the companies’ debt was held in institutional portfolios. As they are not allowed to hold sub-investment grade obligations, the volumes of debt outstanding — US$292 billion at GM and US$161 billion at Ford — resulted in an avalanche of “sells.”

There is liquidity in the bond market, but not
enough to absorb such huge chunks of sub-investment grade debt in one gulp.

Superficially at least, you can suggest that the market overreacted. GM and Ford have no near-term liquidity problems, S&P says in its May 5 announcement. “As a first line of defense, both General Motors Acceptance Corp. and Ford Motor Credit Co. have large cash positions,” it notes. The two also have enormous lines of credit with their banks, make extensive use of the market for asset-backed securities and can securitize almost all their major assets, S&P adds.

For its part, GM had US$40 billion in cash at the beginning of 2005 and only US$2.6 billion of debt matures in the next two years.
Ford has $30 billion in cash and lines of credit and just US$1.5 billion coming due in the next two years. So why the fuss?

It’s because of the fundamentals, says S&P. GM’s SUVs are not as profitable as they
have been; sales are plummeting because of high gasoline prices.

GM will bring out a new line of SUVs in 2006 and 2007, just when Ford plans to bring out its own new iron. For its part, says S&P, Ford is too dependent on sales of light trucks, suffers from a declining market share — also GM’s woe — and owns struggling subsidiaries such as Jaguar and parts-supplier Visteon.

GM has a US$61-billion unfunded retiree medical-care plan liability, while Ford’s is US$32.4 billion. What surplus cash the companies generate will be substantially eaten up paying for the doctor and hospital bills of past workers, S&P notes.

All the costs could be handled if the companies were spinning off cash.
Unfortunately, they are not. S&P says both companies will have negative cash flow in 2005 on an all-in basis, taking account of planned capital spending, contributions to post-retirement benefit plans, the cash earnings of finance units and common stock dividend payouts.

The outlook for GM and Ford bonds is intimately related to the outlook for their cars and trucks. GM, with 14.5% of worldwide vehicle sales and 25.7% of U.S. light vehicle sales, is still ahead of Ford’s 19%,
DaimlerChrysler AG’s 15.2% and Toyota’s 13%, reports S&P. However, GM has too many brands, says the rating agency, and Ford still suffers from heavy, ongoing financing requirements of Ford Motor Credit.

Things change. Chrysler was regarded as a candidate for the boneyard of car brands just 20 years ago and is now, courtesy of its German owner, arguably the healthiest of U.S. automakers.

Moody’s Investors Services Inc. has not yet downgraded Ford’s debt to junk, though on May 12 it dropped it two notches, to one small step above high-yield. As a result, as of mid-May, there remains a mote of grace for the bonds, which remain above junk levels only because of voting rules established by major index makers that tend to require two or more agencies to agree.

Technical factors in index construction could spell further trouble for the automakers’ bonds. In constructing indices: Lehman Bros. Inc. uses the lowest ratings of S&P or Moody’s; Merrill Lynch & Co. averages ratings from the two plus Fitch; and European index builder iBoxx Ltd. takes the lowest of the three agencies’ ratings. By the end of May, as much as US$100 billion may not appear as income on all the reference bases. The reduced income could mean a wave of selling as fund managers, who hug their benchmarks, dump Detroit’s unwanted debt, London-based Financial Times reported May 12.

@page_break@Clearly, sentiment is running against GM and Ford bonds, which appear poised to move out of the ranks of the investment-grade and into the far less liquid high-yield market.

For investors, the current low prices and
high yields of GM and Ford paper are an anomaly.

“Ironically, high-yield debt usually comes with more protective covenants than conventional investment grade debt,” says Dan Vrabac, head of fixed income at Kansas-based Waddell & Reed Financial Inc. “Because the GM and Ford bonds were superior issues, they lacked the protections for investors that many high-yield bonds offer.”

GM won’t have to roll over much debt, Vrabac says, but GMAC will have to issue new debt on near rollovers with better investor protection, such as more asset backing.
Ford is in the same situation, he adds.
“What is still out there as a concern are the
huge unfunded pension and medical benefits,” Vrabac says. “The companies could try to shift those liabilities to the U.S.
Pension Benefit Guarantee Corp., a government agency. That’s what insolvent airlines and steel makers have done.

“Whatever assets remain would go with the liabilities. The employees would have reduced benefits and the stockholders would have nothing. Bond holders would then be left with scraps, but it is too early to tell what a bond workout would give to the holders,” he says.

The longer it goes on, the greater the chance that GM or Ford could go under, says Tom Czitron, managing director, income and structured products, Sceptre Investment Counsel Ltd. in Toronto. “Now investors are asking for a lot of cushion on these bonds.
You are getting paid for the risk you are taking.”

For the cautious investor, GM and Ford bonds do not appear to be worth their risk, Vrabac says. However, an aggressive investor not averse to risk could buy maturities of two years or less, with yields of 6% to 8%, about 300 to 400 bps over a two-year U.S. Treasury at 3.70%, he says.

While there are safer investments, GM and Ford bonds currently pay at a rate characteristic of bonds with even lower ratings than S&P has assigned, says Chris Kresic, senior vice president for investments at Mackenzie Financial Corp.in Toronto.

They are not for the faint of heart, but the bonds are far from a writeoff. Nobody ever said that there’s money to be made without some risk. IE