What's behind plummeting values in corporate bonds?

Falling knives: Pimco ponders what explains sharp reversals on credit valuations despite improving fundamentals.

The credit market faces a paradox: valuations have taken a dive at a time when market fundamentals are improving. Charles Wyman, executive vice president and head of credit research at Pimco in the United States, says the reason is not fear of default, but of tensions in the high-yield market.

Credit fundamentals remain strong after a sharp recovery that began in 2003, he says. Balance sheets are in good shape, with S&P500 companies having generated $50 billion in free cash flow in 2004, or three times the amount on balance sheets in 1997. Default rates hit a peak in 2002 but have fallen to 1997 levels should stay there throughout 2005. Meanwhile recovery rates have risen, particularly on unsecured bonds.

Despite this rosy outlook, over the past two months, corporate valuations have suffered, with the Lehman corporate index showing option-adjusted spreads widening by 30 basis points, and the BBB-rated segment widening by 50bps. "The culprit has been the autos," Wyman says, "which have experienced a near doubling in spreads since GM announced revised guidance for 2005."

Standard & Poor's downgraded GM and Ford debt to junk status on May 5.

This has sparked a market sell-off despite overall improving fundamentals. Today Baa-rated option-adjusted spreads trade at 160bps, versus 75bps in April, 1997, when fundamentals were in similar shape.

"The spectre of default is not what is driving credit spreads," Wyman says, noting default rates are approaching historic troughs, and that corporate liquidity for S&P industrials has reached record levels. Likewise for the autos, the culprit behind the sell off, the prospect for default is just as remote, Wyman argues. GM and Ford together have $200 billion of gross liquidity on their balance sheets.

The current spreads on 2-year GMAC unsecured senior debt only make sense if you expect the probability of default in the next two years to be in the 20-25% range, while spreads of 9-year GMAC unsecured senior debt make sense only if the probability of default is in the range of 50-90%. Wyman thinks such assumptions are ridiculous. "No one trading these bonds really believes GM will default in the next two to five years," he says. In fact, he believes GMAC will probably return to the investment-grade index within a year, although GM is expected to remain in high yield indices for some time. "Clearly these credit spreads are paying for something dramatically more important than default risk."

Bond holders are receiving 200-300bps for excess yield volatility versus treasuries that can't be eliminated through diversification, he says. What this means is that as issuers move down the credit ratings spectrum, it increases the risk that holders will try to diversify away. That's because not all credit ratings are stable: while a triple-A rated bond is likely to stay that way, one rated Baa has a higher chance of a downgrade.

Value at Risk (VaR) increases as volatility rises, because the capital at risk also rises. This prompts bondholders to sell, in order to reduce capital at risk - which in turn adds to volatility. "VaR is the link between volatility and liquidity," Wyman says.

In the case of GM and perhaps Ford, the source of volatility is the prospect of a downgrade to high yield.
GM can handle such a downgrade because of its massive liquidity, but the sheer scale of over $40 billion in debt will place huge pressure on the high-yield market, Wyman says. The investment grade corporate market in the United States is $1.7 trillion. The high yield market is $700 billion. Adding $40 billion to that is problematic. Few high-yield managers can have a big exposure to any one company in their portfolio, so they'll have a hard time assimilating GM bonds. Moreover high yield managers are not duration managers, they eschew securities beyond 10 years. That explains why bids for GM's longer-dated securities remain depressed. And high yield managers have little experience with car manufacturers, and have no intuition about how these bonds should trade.

"This leads to volatility," Wyman says, as many bondholders will try to sell their GM names to a market that's not prepared to absorb them.

"The prospect of massive amounts of auto debt moving into high yield has created fault lines across markets and for some period will limit investors' ability to diversify away idiosyncratic credit risk," he says. "Volatility is likely to remain high until we see some stabilization in auto-reported results, or redistribution of auto debt in high yield."

So many bond managers are staying on the sidelines, despite the positive fundamental story elsewhere in the market. Wyman compares the current situation to trying to catch a knife: "The best way is to pick it up off the floor."

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