The bruising seven days began last Thursday (May 5) with the surprise downgrades of Ford and General Motors to junk status by Standard & Poor's — and ended yesterday (Thursday), when Moody's cut two notches off Ford Motor Co and Ford Motor Credit Co's ratings, bringing the manufacturing arm to the bottom rung of investment grade.
Spreads on the US car makers' bonds rose relentlessly until yesterday, but paradoxically, Moody's downgrade was the signal for the widening to slow down, and even stop, in Ford's case. Traders and investors were relieved that Moody's had left Ford at investment grade and not cut its short term rating of P2, which affects its commercial paper funding.
The turmoil among hedge funds, sparked by the S&P downgrades, hit structured credit and convertible bonds particularly hard, with severe mark-to-market losses on many positions.
But the threatened apocalypse has so far failed to arrive. Top quality borrowers like GE Capital, Berkshire Hathaway and Citigroup got corporate bond issuance going again in the US, where over $10bn of bonds were launched, down to the triple-B level.
In Europe, the corporate bond market remained much more nervous, but the European Investment Bank launched a highly successful 30 year bond and BMW Finance, the lending arm of the German car maker, almost flaunted its superiority to its US rivals by issuing a Eu400m deal.
Even Brazil and the Philippines were able to fund successfully, launching deals of $500m and $750m.
And in the credit default swap market, which was buffeted by these worries for most of the week, some clarity and calm began to return yesterday.
"The good news is that we cannot really come up with one or more [hedge fund] names that we know which are under severe stress," said Krishna Memani, head of investment grade credit strategy at Credit Suisse First Boston in New York. "They might be suffering losses but I think if they were under severe stress — that is, getting customer calls and suffering liquidations — we would hear of it, and we haven't."
Many hedge funds have had to undo positions in the cash and derivative credit markets because they were hit by Ford and GM's widening or because investors have pulled out their money.
In particular, many funds had gone long the equity tranches of credit default swap (CDS) indices and short the mezzanine layers, betting that credit spreads would widen but there would be few major debt defaults.
Isolated, severe spread movements like those in Ford and GM are the worst outcome for this kind of trade, ruining the value of the equity tranche and lifting the mezzanine, which represents the basically stable wider credit market.
The worsening credit volatility since early March is the first serious test of the new system in the fixed income markets, in which credit derivatives, collateralised debt obligations (CDOs) and hedge funds play a powerful part.
If investors feared that part of the system could collapse like a house of cards, they would have been relieved to see so much normal bond issuance get done this week, largely without the participation of hedge funds which lead managers are now accustomed to.
GM, Ford widening slows
After some General Motors bonds widened as much as 150bp this week, spreads for GM and Ford paper came off their wide levels yesterday, when Moody's announced early in the New York afternoon that it had taken Ford's rating down from Baa1 to Baa3 and Ford Motor Credit's from A3 to Baa2. Moody's outlook is negative.
Although Moody's now has Ford at the lowest investment grade level, its action took some of the uncertainty out of the market.
"The market definitely pushed things a little wider when it heard that Moody's was coming out with something on Ford, but the fact it remained investment grade has been taken as something of a positive," said a syndicate manager at one of the top bond houses in New York. "People realised Ford will now be investment grade for a good bit of time going forward."
At yesterday's close, Ford 2031s were at 544bp, 6bp wider on the day but better than last Friday's 550bp level .
GM's 2033s were still drifting wider at the close at 714bp, about 27bp wider on the day. Even so, traders said the tone was a touch better and that daily spread widening had slowed from the 58bp slide that GM's 2033s suffered at the beginning of the week.
The rest of the market also enjoyed a reprieve yesterday from a sell-off earlier in the week on concerns about hedge fund losses in the CDO and derivatives markets.
Although uncertainty about the health of hedge funds remain, the lack of any one severely distressed fund surfacing by yesterday helped give spreads some support.
High grade bonds have also suffered less than other markets from hedge fund concerns. Although they have been as worried as any other group of market participants, high grade bond investors expressed their risk aversion by buying protection in the credit default swap market rather than selling corporate bonds.
Investors still want to hang to their bonds when corporate paper is in such limited supply.
In or out?
Despite the better tone yesterday, car companies' spreads will remain vulnerable while confusion over their inclusion in the high grade bond indices remains.
"We could have a very unusual situation where for the month of June Ford and GM are out [of the Lehman Brothers index] and then get re-included on July 1, when Lehman's new exclusion rules come into effect," said Ed Marrinan, head of high grade credit strategy at JP Morgan in New York.
Under current rules, issuers with one speculative grade rating from either Moody's or S&P — like Ford and GM — are excluded from the Lehman index. So the two companies are set to be ejected at the end of May.
But they are set to come back in on July 1 when Lehman changes its rules to determine eligibility by the middle of three assigned ratings.
However if Fitch or Moody's downgrades either company to junk, it will be out of the Lehman index for the foreseeable future.
Although Ford seems assured of a spot in the high grade index for some time — Moody's has just acted and Fitch still rates it BBB+ — the fate of GM seems more doubtful.
General Motors is now rated Baa3/BB/BBB- and GMAC Baa2/BB/BBB-.
"While we have reached levels that reflect some of the problems these companies face, we are still looking for another shoe to drop and any credit rating downgrade [of GM] will have an adverse impact on the market," said Marrinan.
Until then, high grade investors benchmarked to indices are sitting on their hands.
"Many investors believe it is foolhardy to sell at the end of May only to have to buy back these bonds in six weeks when the new index inclusion rules come into force," added Marrinan.
Indexed high grade investors are considering various ways round the conundrum, such as classifying auto bonds temporarily as an 'out of index' play or carving out exposure into a separate 'auto only' bucket and lobbying their investment committees to let them hold auto paper until new inclusion rules apply.
