For the auto sector's Big Three life in the capital markets has become a lot more difficult. Their funding strategies have come under intense scrutiny and their benchmark bonds are being used as cheap hedges by some investors. For the once stable sector, spread watching is now the name of the game. In the following three articles, Neil Day and Danielle Robinson report on the progress of US autos in the international bond markets.
As hard as it is to imagine, there was a time - and not all that long ago - when Ford Motor Credit Company (FMCC) and GMAC traded on top of one another, auto spreads were the most stable in the dollar corporate bond market and it was Chrysler that everyone loved to hate.
Today FMCC is the underdog, having traded 100bp wider than General Motors Acceptance Corp (GMAC) earlier this month (September), an unprecedented differential between the two.
DaimlerChrysler is now the darling of the so-called Big Three, with five year dollar spreads 160bp tighter than GMAC and 260bp through FMCC. To cap it all, autos are rivalling the telecoms industry for the title of the most volatile bond sector of the year.
This has all happened despite FMCC and GMAC's funding needs this year being about half of what they were in 2001 - they are widely considered to be in a far better position now than this time last year in terms of balance sheet strengthening, cashflow generation and financial flexibility.
A continuing decline in market share to foreign companies like Toyota, persistent concerns about how much longer Ford and GM can absorb the costs of 0% financing and other incentives to boost sales, problems with growing pension fund liabilities and difficulties surrounding labour negotiations in Canada have all hit the US auto spreads at various times this year. Credit specific issues, like such as Ford's downgrade from A3 to Baa1 by Moody's and its ability to continue meeting expectations related to its revitalisation plan announced in January, have also weighed in.
Mirroring macro trends
Most of all, the cyclical auto sector and its abundance of highly liquid bonds has made it an investor favourite for shorting the corporate bond market as a whole when panic sets in over the direction of the economy. "The key worry for the sector is the macro-economic picture," says Christophe Boulanger, auto analyst for Dresdner Kleinwort Wasserstein (DrKW) in London. "If you have negative macro-economic indicators coming into the market, the first to be hit is the auto sector."
This has been especially true given the perception that the consumer has been the engine for the US economy. A report published by Commerzbank at the beginning of September highlighted this, finding a close correlation between US auto sales and consumer confidence since 1980. The bank thus identified the auto sector as a "barometer" for the credit markets, and added: "The consumer has been underpinning economic growth for some time now, and his health may set the overall tone of credit markets for the months to come."
This is hardly front page news for issuers like GMAC and FMCC. But what has been something of a revelation this year is the extent to which jumbo global bonds launched in the bull markets of past years have become dead weights in today's volatile times. "In a bull market environment the large liquid benchmark transactions were viewed positively and as a result they tended to outperform in an improving economy," says one head of global bond syndication in New York. "In a negative environment, larger deals can be viewed as hedging vehicles. Investors have been more willing to short them because they can be borrowed and covered so much more easily than less liquid bonds."
FMCC, having issued more jumbo globals than anyone else, has been the biggest victim. Many investors have also used FMCC's highly liquid dollar deals as a cheap hedge on credit blow-ups. "Even though autos are a pure old economy sector, with little to no room for accounting scandals, they have received collateral damage because they have so much presence in the debt markets," says Bill Cunningham, a senior credit strategist at JP Morgan in New York. "When the whole market sells off investors find it easier to sell autos because they are so liquid. At various times this year the auto sector has been the most popular vehicle for making a negative statement on the corporate bond market as a whole, even if the sector doesn't have the sort of accounting problems that is causing volatility."
This "technical issue", as analysts call it, was most evident in July and early August, when, in spite of announcing better than expected second quarter earnings, GMAC and FMCC suffered some of their worst spread volatility all year. For the first 5-1/2 months of this year the auto sector had been the best performer in the corporate bond market. But when fears of a double-dip recession reasserted themselves during the summer, spread levels deteriorated sharply on GMAC dollar bonds and even more so in FMCC's case. By the end of August, FMCC 2011s had gapped out 70bp to 375bp from already dismal end of July levels. GMAC 2012s were wider by 38bp at 293bp. DaimlerChrysler, with the fewest large globals and perhaps the best credit story, experienced far less widening.
According to DrKW's Boulanger, FMCC has suffered more than GMAC because, apart from GM's better performance than Ford, "FMCC is considered by hedge funds to be more likely than the others to have stable to negative headlines and it also has the biggest and most liquid bonds out there."
With hindsight, some market participants ardollar global bond market in the last several years as having contributed to its now record wide spread differential between itself and GMAC. Had it not been so vocal about its jumbo globals and instead diversified its sources of funding, say bankers, then maybe its spread levels would not be so far behind.
With intra-day price swings of as much as 50bp in the auto sector in recent months, pinning down what has caused spread widening in one auto credit versus another is a major feat. Even so, the degree to which liquidity has been exposed as a double-edged sword is having an impact on auto funding strategies.
Euro outweighs dollar
Up until late August, when GMAC pounced on a brief issuance window and sold $2.5bn of five and 10 year globals, autos had issued more in euros than dollars this year. DaimlerChrysler made one hit on the dollar markets in the first week of January and has not been seen since. FMCC's widely applauded GloBLS (Global Landmark Benchmark Securities) programme for large liquid benchmark dollar globals, meanwhile, has all but shut down.
The company has issued $2bn of dollar globals in the market this year, compared with $19bn in 2001 and a similarly large amount in 2000. Although it has made room in its 2002 funding plan for $5bn of globals, it is unlikely to return to the dollar market again this year unless spreads improve. "You may or may not see an additional global bond done this year," says David Brandi, director of long term debt and securitisation at FMCC in Dearborn, Michigan.
Brandi acknowledges that contributing to widening spreads this year has been the amount of highly liquid dollar bonds it has outstanding. "It is a fact that we are the largest participant in the Lehman aggregate index," he says. "If investors are concerned with corporate credits, we are the easiest to sell."
Brandi's funding strategy is now to further diversify its borrowing sources by building up the Cobras (continuously offered bonds for retail accounts) retail note programme it established earlier this year, and raising a greater percentage of its funding through asset backed securities. "As things have deteriorated economically and as our ratings have come under pressure, we have moved more extensively to the securitisation process," says Brandi. "We have a long track record in the asset backed securities market and it offers us excellent pricing."
FMCC can issue triple-A one to three year structured notes at 10bp-20bp over Libor, compared with trading levels of 300bp-400bp over Libor on any given day during the summer in the unsecured markets. But as important to Brandi as pricing is access. In August, when its five year bond spreads moved to over 500bp, FMCC issued a successful $3bn structured transaction via Citigroup/SSB and Merrill Lynch, which was increased from $2bn and priced at or through the tight end of price guidance levels.
FMCC's plan is to raise $32bn-$37bn this year, a little more than half the $60bn it raised in the secured and unsecured markets in 2001. Of that, $2bn-$5bn will have been raised in dollar globals (compared with the $19bn in 2001), $8bn-$10bn in foreign currency ($17bn in 2001), $5bn in MTNs and retail notes ($4bn) and $17bn-$22bn in asset backed securities ($20bn). The proportion of asset backed funding will thus rise from around one-third of FMCC's 2001 funding to about half for this year.
FMCC's declining reliance on globals and greater diversification this year mirrors to some extent the funding decisions that GMAC has taken in recent years, from which, say many bankers, it has reaped rewards. "GMAC has done a masterful job of developing as many new markets as possible, timing the markets correctly and camouflaging the amounts of borrowing it has done in the past 20 months," says Chris Whitman, managing director, debt capital markets North America for Deutsche Bank in New York.
At the core of GMAC's funding philosophy is diversification and balance, says Cynthia Ranzilla, vice president, US funding and global markets in New York. "The common theme for GMAC's funding strategy is to try to strike a balance between the various different funding sources available," she says. "We are proactive in accessing diverse funding sources, and this has been true year over year."
GMAC started seeking alternative sources of funding years before many major borrowers. It has been issuing notes in the retail market, for instance, since 1996, five years ahead of FMCC. "Frankly, GMAC's success with its SmartNotes programme has led to at least 12-15 other borrowers setting up similar programmes," says Whitman. It has also made much greater use of reverse inquiry and other trades in the euro and dollar MTN markets than its peers.
In doing so, GMAC has skillfully disguised its large funding needs. "Over the last couple of years Ford has been a much louder proponent of these large benchmark liquid jumbo deals," says a head of global bond syndication in New York. "Last year people believed that Ford was issuing much more frequently than GMAC, but in reality that was not the case."
Both companies had abnormally large amounts of funding to raise last year, to pay down about $60bn of CP between them in anticipation of a slowing economy and subsequent pressure on their ratings. GMAC ended up raising $65bn last year, slightly more than FMCC's $60bn. But while the two did an excellent job of raising record amounts of funding last year, they did so in notably different ways.
MTNs in focus
GMAC's capital raising breakdown in 2001 was $26bn of unsecured debt ($20.6bn in dollars and $5.4bn in other currencies), $17bn of MTNs (about $2.6bn in other currencies), $8.5bn of retail SmartNotes and $13bn of asset backed securities. "GMAC has made great use of the term MTN market and has been extremely opportunistic," says a head of high grade debt syndication.
GMAC also elected not to establish a benchmark global note programme, despite the overwhelming acclaim in the market for FMCC's GloBLS innovation when it was established in 1999. "We looked at the programme at the time and saw some of the limitations as not beneficial in the long run, especially in weaker markets," says Ranzilla. "Overall, GMAC's position was that benefits could be obtained by larger deals when investors were more receptive to jumbo transactions."
Ranzilla was concerned that such a programme would cramp GMAC's style of tailoring bond issuance to hit pockets of investor demand as they arise. "The programme entailed certain minimum requirements on deal size," she says. "In a strong corporate bond environment having a minimum size would not be an issue. However, a critical element of GMAC's funding strategy is to be flexible and nimble. The ability to react quickly to changing market conditions and to revise the approach to market-based on investors' receptivity is imperative."
GMAC's expertise in making well timed opportunistic hits on the global and Eurobond new issue markets this year also goes some way to explaining its better spread performance compared to some of its peers.
When GMAC decided to tap strong global dollar markets on January 24, it made a strong statement to the market about its smaller funding needs this year relative to 2001. When it announced the $2bn issue, which comprised equal five and 10 year tranches, GMAC said that it would not increase the size of the deal and reiterated its modest needs for the year. That strategy instantly rebalanced the technicals on GMAC paper. (At the time there were some investors shorting GMAC paper in expectation that it would be issuing similar amounts this year as last.) Spreads on its outstandings tightened 15bp -20bp when the deal was announced and the 10 year was priced at 205bp over, about 10bp through secondaries at the time of the announcement.
Its $2.5bn issue of fives and 10 year bonds on August 22 was another example of its skill at spotting an issuance window and immediately acting on it. Had it not moved quickly to jump on a sudden rally in auto spreads that week, it would have found itself competing with a flurry of other opportunistic issuers trying to get deals done around the US Labor Day long weekend and the September 11 anniversary. Auto spreads have also backed up since then.
Diversify, diversify, diversify
Diversifying one's funding sources and making a balanced use of the debt markets might not sound like a particularly inspired strategy, but it is one that many market participants did not fully appreciate until they saw how much it has put GMAC ahead of the game. By maintaining a steady presence in the retail note market over the years, GMAC was able to raise $8.5bn of SmartNotes in 2001 when its needs were abnormally high. Similarly, by having that option open to it last year, GMAC has kept its funding options more open this year than they might have been had it raised the $8.5bn elsewhere. "If the retail market had not been able to shoulder so much of its funding needs last year, things would be a lot tighter for GMAC in the asset backed securities and term debt markets in terms of the liquidity available," says one debt capital markets official in New York.
This year GMAC has continued to pursue a balanced funding mix. It has between $25bn and $30bn to raise this year. By the end of August it had issued about $8bn in unsecured debt - about 40% in Eurobonds - $1bn of MTNs, $6bn of SmartNotes, and $6bn of asset backed securities. As a percentage of total funding, GMAC has done a little more secured issuance this year than last, partly because the cost difference between secured and unsecured debt has been much greater this year than for most of 2001.
Notwithstanding the better pricing it can get in asset backed securities, GMAC is being cautious about how often it taps that market. Part of that has to do with the short average life of two years or less for its structured funding. "As an issuer with a fairly large funding programme, GMAC is aware of the need to extend maturities to enhance the liquidity position," says Ranzilla.
If anything, she adds, GMAC has underplayed its capacity in the asset backed market and, given the global economic and political uncertainties ahead, that is a good situation to be in.
Although not prepared to say whether she is keeping excess capacity in the asset backed market for emergencies, Ranzilla admits: "We certainly appreciate that the asset backed market is not as affected as the unsecured markets with respect to the direction of the economy since it is based on the quality of the collateral supporting the securities. The asset backed market has shown its resilience over the last few years and it is important for GMAC to maintain capacity in that market."
With so much uncertainty ahead, investors are anxious to know that the auto companies have prepared themselves for any further economic weakening and pressure on ratings. Ford Motor Company and FMCC's obsession with staying highly liquid has put the corporate in a strong position to weather worsening times, say analysts. "Despite a very difficult industry environment, Ford still maintains a formidable liquidity position with a relatively light debt maturity schedule, which should provide adequate credit protection as the company executes its revitalisation plan," says Eric Riffer, a US auto analyst at Citigroup/SSB in New York.
"Liquidity is extraordinarily important to our investors and we have focused on it for what seems forever," says FMCC's Brandi. "In the last 18 months we have put in place a number of things that have been important for liquidity. We have over $33bn of credit lines, two-thirds of which are multi-year agreements with banks. In addition to that we have put in place contractual agreements with several multi-seller conduits, giving us the right to sell with two days' notice up to $12bn of assets and receive up to $12bn of funding from it." At the end of June FMCC had used about $4bn of those facilities.
"We have also put in place two asset backed CP conduits," adds Brandi. The first, called FCAR, has seen outstandings jump from $1bn in mid-2001 to $11bn at the end of June this year. Its other CP conduit, Motown Notes, was introduced at the beginning of this year. It is backed with fast turning wholesale receivables and only requires a 5% liquidity back-up.
FMCC also has capacity in the retail and the asset backed securities markets. Although FMCC has done a lot in the secured market recently, bankers on asset backed security syndicate desks point out that it also has an awful lot of paper rolling off. With so much volatility in the corporate bond market, investors also have a strong appetite for triple-A secured product, especially for that issued by household names like Ford.
GMAC is considered to be in an even stronger position. It has excess capacity in the asset backed market and a thriving SmartNotes business where Ranzilla thinks it can write another $6bn of notes. GMAC has also expanded its retail issuance to include a presence in the $25 par notes market, targeted at preferred stock investors. GMAC is also keeping a close watch for further opportunities in the unsecured debt markets, especially euros, which have been trading tighter than dollars.
Eyes on the market
If market opportunities presented themselves, says Ranzilla, GMAC would also consider prefunding: "If the economy gets worse, GMAC would reassess its funding position, identify the markets that are available and adjust the funding programme accordingly. Having flexibility and access to diverse funding sources is so important in those market conditions and the reason not to rely too heavily on one market versus another."
While GMAC has benefited from the way it has camouflaged its large funding requirements, DaimlerChrysler's funding needs have been far lower than either of its US competitors. This helps explains why, despite having ratings on a par with General Motors' senior unsecured ratings (A3/BBB+), and being rated one notch lower by Moody's than GMAC (A2/BBB+), DaimlerChrysler trades tighter than its peer in dollars and especially in euros, and why its bonds have been less volatile.
For example, analysts at BNP Paribas have been recommending investors switch from DaimlerChrysler's 5.625% January 2007 issue into GMAC's 6.125% March 2007 line. In the first week of September, investors could pick up around 100bp by making the switch to the slightly higher rated paper. However, this pick-up was even wider than two weeks earlier, before GMAC raised $2.5bn in the dollar market, highlighting the supply considerations that partly explain DaimlerChrysler's advantage.
"They are fundamentally a weaker credit than GM and perhaps closer to Ford if you look at some of the credit metrics and away from the operational side, but their huge advantage is that their funding needs have been very limited in comparison to Ford and GMAC," says one global syndicate head. "That lack of paper sloshing around the market and modest of new issuance is holding their spreads in."
Bankers say that as well as having modest funding needs compared with its US peers, the company has pursued a sensible strategy in the capital markets. "DaimlerChrysler comes in and typically borrows in euros rather than dollars, and then basically hits an MTN here or there in Eu500m-Eu1bn, which tends not to affect their spread as much as they did in a jumbo deal - as some groups have done in the past," says David Meade, a credit research analyst at Morgan Stanley.
Another boost for DaimlerChrysler comes from its ability to leverage off strong support for its name in Europe. "Because of the scale of their funding needs, the domestic German bid is still felt in their spreads," says Sean Park, global co-head of debt syndicate at Dresdner Kleinwort Wasserstein. "At some level of volume you swamp that, but they are still at a level where it still filters through, even if it is not as striking an advantage as it once was."
European investors acknowledge the European following that benefits DaimlerChrysler, and even those that feel the company's fundamentals do not justify its trading levels still see attractions in its paper. "DaimlerChrysler is still in the position to benefit from its strong brand name and because of that they trade at tighter levels," says Rüdiger Rohner, team head of cyclical credits at Deka Investment. "And even if from a pure rating perspective it looks incredibly expensive, from a volatility-adjusted point of view it looks fairly interesting. It benefits from a kind of self-fulfilling prophesy:one of the main reasons why it remains stable is because everybody believes that it will remain stable."
An unmissable exception to DaimlerChrysler's funding strategy was the $7.1bn transaction it launched in January 2001, increased from $4bn after attracting a staggering $24bn in demand.
By launching the transaction, the company was able to take out a large chunk of its funding for the year and limit any supply overflow by raising the money in five tranches, across three currencies - dollars, euros and sterling - and four maturities.
Nevertheless, the transaction highlighted the different standing the company enjoys in with US institutions and European accounts, being priced off DaimlerChrysler's dollar curve and in line with credit default swaps. "They came incredibly cheap at 130bp over Libor," says one continental European investor of the Eu2.75bn three year tranche. "Everybody was wondering why it was such a bargain and it became clear that it was priced off DaimlerChrysler's US levels. That goes to show what a special position the company enjoys in Euroland."
Nevertheless, investors in DaimlerChrysler's bonds will be looking just as keenly at its results when the third quarter reporting season begins with GM's results on October 15. And at this stage, most analysts are optimistic about the prospects of the Big Three. Many expect FMCC spreads to tighten in sharply if the outlook for the economy improves.
"It is difficult to say where spreads are going in the short term because near term sentiment is likely to be driven by uncertainty surrounding a potential conflict in Iraq and its impact on the economic environment, hence our marketweight stance on the sector for the time being," says Boulanger at DrKW. "But if you are buy and hold investors or willing to own paper for at least six months, we would regard any excessive spread widening as a good entry point on FMCC and GMAC. If you look at their spreads and the improvement over the last six months... you would expect their spreads to tighten once headlines regarding a military engagement in Iraq subside."