Pressure grows on GM bonds

General Motors bond prices have dropped to their worst levels of the year as the uncertainty surrounding the US motor vehicle maker's commitment to buying Fiat of Italy weighed on sentiment in the market.

On Wednesday, the two companies agreed to enter mediation talks to resolve their dispute over a put option that could force GM to buy the 90 per cent stake in Fiat that it does not already own.

The groups will meet within the next 20 days to try to resolve the issue. If they fail, the dispute could end up in court.

GM is already under pressure from weak vehicle sales in the US and large pension and healthcare liabilities. Following disappointing third-quarter earnings, Standard & Poor's downgraded the company to Triple B minus, the lowest investment-grade rating.

The rating agency said on Tuesday it was concerned about the potential ramifications of this situation for GM's credit quality, adding that a downgrade to junk status was unlikely - but could not be discounted. Its outlook is currently "stable".

A downgrade to junk status would have significant implications for the bonds and for the whole bond market. Despite their recent widening, history shows that the bonds are likely to be hit again if the outlook on GM is changed to "negative".

When Fiat was relegated to junk status two years ago, yield spreads - the premiums investors demand to own corporate bonds rather than government debt - had more than doubled in the three months after it was placed on CreditWatch with negative implications. Six weeks after being placed on CreditWatch, later, it was downgraded.

The yield spread on GM bonds has widened sharply since the summer, bucking the trend in the rest of the corporate bond market.

Having hit their worst levels of the year this week, the yield spread over the Bund on both the GM 2033 issue and the 2013s, the most actively traded instruments, tightened 2 basis points yesterday.

However, coming on the back of a 100bp spread- widening since June, the bounce did little to improve this year's performance.

"We continue to believe that S&P is guiding the market towards an eventual downgrade to junk for both Ford and GM," said Suki Mann, credit strategist at SG CIB. "Support will fail to emerge to help halt the steady and continual decline in their spreads."

A downgrade would also have significant implications for the whole bond market. GM and its chief rival Ford Motor, which faces many of the same challenges, are the second and third largest players in the global corporate bond market both in the US and in Europe.

With ?28.5bn of bonds outstanding in Europe, the two companies account for 8 per cent of the Iboxx corporate bond index and more than 40 per cent of the auto index.

If they were downgraded, funds that are restricted from owning speculative-grade bonds would become forced sellers and would have to place their money elsewhere. A downgrade would also increase the relative proportion of other sectors in the indices, which fund managers use a benchmark for their performance.

This should technically benefit companies in other large sectors, such as telecommunications and utilities, but, a downgrade of one or two of the largest companies in the market would not happen in a vacuum.

"The relative boost to other sectors is likely to be more than offset by an increase in general risk- aversion," said Ben Bennett, credit strategy analyst at BNP Paribas.

Robert McAdie, global head of credit strategy at Barclays Capital, said that the US motor vehicle sector posed one of the biggest risks in an otherwise benign bond market environment next year.

GM and Ford will need to refinance $50bn of debt in 2005, which would be much harder if GM were downgraded to sub- investment grade.

On the plus side, Mr McAdie expected contagion by other sectors would be limited because the market fundamentals are otherwise strong. He said the question for investors was whether to "ride the carry" - borrowing short to finance higher yielding long-term bonds - while reducing risk through a stop-loss contract - or to sell out now.

One possible outcome if GM were downgraded would be to ringfence GMAC, its financing arm, while putting GM into Chapter 11 bankruptcy protection.

This would allow a restructuring while freezing its healthcare and pension obligations. That scenario is still some time away, but the downward pressure on Ford and GM bond prices is not likely to abate in the near term.

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