Fallen angels

In having debt cut to junk, GM was following a trend among brand-name firms

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When bond rating agencies downgraded General Motors in May, the world's largest automaker joined an exclusive club, or rogues' gallery, if you prefer.

In recent years, a number of other household-name companies - Xerox, AT&T, Eastman Kodak, Maytag, Enron, Tyco, Lucent, WorldCom, RJR - saw their debt drop from investment grade to speculative grade, or "high yield" securities.

They became fallen angels, in the parlance of the bond market.

In some cases, notably WorldCom and Enron, fallen angels slid into default and bankruptcy proceedings.

But a halo appeared almost immediately around GM, as its bonds rallied from mid-May to mid-June.

Fallen angels represent about 27 percent of the speculative-grade corporate bond market, according to Merrill Lynch & Co. Inc., which estimates the size of the market at $654 billion. Ten years ago, the proportion of fallen angels was 17 percent.

"We've seen a fairly dramatic increase in the proportion of the [high-yield bond] index that is fallen angels," said Preston Peacock, research analyst in the portfolio strategy and index group at Merrill Lynch.

The remainder of speculative-grade bonds, also known as junk bonds, mostly are bonds of smaller companies that were rated "junk" from the day they were issued.

For high-yield bond investors, the distinction between fallen angels and newly born junk bonds is important.

As the economic expansion matures, the credit quality of original-issue junk bonds has been decreasing.

According to Standard & Poor's, nearly half of high-yield bonds issued this year hold ratings at the lower end of the junk-rating scale.

At the same time, the number of investment-grade companies falling into speculative-grade status has increased over last year, S&P reported.

With more fallen angels at one end of the market and riskier original-issue junk bonds at the other end, the distinct investment characteristics of the two sectors of the junk-bond market will become more prominent.

The debt of General Motors and subsidiary General Motors Acceptance Corp. represent a substantial portion of the junk-bond market.

"There are some material differences in analysis between fallen angels and original issues, mostly to the disadvantage of fallen angels," said strategist Martin Fridson, chief executive of FridsonVision LLC, a bond market analysis service.

Fridson lists these warning signs regarding fallen-angel junk bonds:

Large, established companies that lose their investment-grade rating frequently rely on bank financing and short-term commercial paper to finance their daily operations.

"If their credit lines get cut off by the banks, they can be in serious jeopardy very suddenly," he said.

Original-issue junk bond companies typically are small firms that do not have access to commercial paper or significant bank financing. In other words, they have less to lose.

Fallen-angel companies usually issued their bonds without covenants that protect bondholders. Covenants include restrictions on additional debt issuance, change-of-control rules and limits on dividends.

"You don't have to offer much in protective bond covenants for a bond that is investment-grade rated," Fridson said.

Original-issue junk bonds frequently include a number of protective covenants.

Fallen angels may have long maturities - more than 10 years. Long maturities expose investors to more risk and price volatility.

Original-issue junk bonds typically reach maturity in seven to 10 years from the issue date.

But fallen angels have advantages, as well:

Companies that become fallen angels frequently have a stable business, with consistent cash flow and well-known brands, said Diane Vazza, managing director of high-yield analysis at Standard & Poor's.

"A company that is born high-yield might have greater business risk and greater volatility in earnings and cash flows."

Fallen-angel bonds are discounted well under par value - or the value they will have at maturity, Vazza noted.

Buying a bond below par offers the potential of a capital gain. Many original-issue junk bonds lack that potential as they mature.

After a three-year period of trading as a speculative-grade bond, a fallen-angel bond has a better chance of winning an investment-grade rating than a comparable original-issue junk bond, Vazza said.

A fallen angel, however, does stand a better chance of default in the first few years after it is downgraded than a comparably rated original-issue junk bond.

Todd Youngberg, global head of high-yield investing at ABN Amro Asset Management, said his approach to fallen angels is to nibble.

"Our approach to fallen angels has been very gradual," reflecting the risks, he said.

Mark Vaselkiv, head of high-yield investing at T. Rowe Price, likes fallen angels.

"Overall, it has been a very profitable area for high-yield investors to focus on," he said.

"When the companies move from investment grade to high yield, there is a dislocation. Fund managers get spooked a little bit. We took reasonable positions and it worked out well."

The Chicago Tribune is a Tribune Publishing newspaper.

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