Junk Driving

06 June 2005 By db staff writer

d=”standfirst”>Bidders for Allied Domecq might find their ambitions crashing head-on into the newly increased cost of raising finance through bonds, says Matt Guarante

WHAT DO you get when you put cars and drinks together? Normally, trouble with the law, and it’s the drinks that are to blame. Early in May, an event happened that means, at a corporate level, cars are very, very bad indeed for drinks. The corporate debt of two leviathans of the carmaking world, General Motors and Ford, was assessed by the most powerful ratings agencies – and found wanting. The implications of this judgment are that any company, in the drinks industry in particular, is now going to find it harder, and perhaps more expensive, to borrow money. In particular, it means that those companies pursuing Allied Domecq, that had intended to borrow money to do the deal, might find that the cost of financing has shot skywards. Bond market insiders say as much as two percentage points could be added to effective interest rates. How has this come about? In the world of corporate bonds, there are two levels of credit worthiness. One is called investment grade; the other, with the gusto for posturing and name-calling so beloved of bond market operators, is simply labelled “junk” (or, if you are a little more genteel, high-yield). Within these divisions, there are seemingly infinite levels of worthiness and junkiness denoted by a series of letters, numbers, and plus and minus signs. So while government-issued bonds are seen as cast-iron solid, the flakier a company the lower its rating is going to be. Ford and GM have just been put in the junk category. This brings the companies two headaches. First, institutional investors (mainly pension funds) who buy these bonds and associated instruments have clear guidelines about what they can and cannot buy; many have a no-junk remit. As a result, many funds will have to sell their GM and Ford bonds. Second, because the perceived risk is higher, the cost of borrowing money for the companies (effectively, bonds are fixed-term loans) is higher; the interest that the bond issuer has to pay to get fund managers to buy those bonds rises accordingly. Now, GM and Ford are not exactly basket cases, and the financial world has known for some time that this event could happen because the agencies put companies on “review” if they think there needs to be a re-assessment of how risky their business is. GM and Ford both have little chance, at present, of defaulting. But their ability to get credit is hampered by the fact that their credit scoring is not as good as it once was. Now we come to the real whammy – the fact is, GM and Ford between them have just over US$450 billion (yes, billion) of bonds and similar kinds of financial instruments currently floating around the market. Bond-market watchers say this has poured yet more fuel on what was already a well-fed fire, raising the yields on highyield corporate bonds relative to standard bank borrowing rates, and increasing volatility. The weight of all that money is creating problems of its own; there is some doubt whether the fund managers who have to sell their holdings will actually be able to find buyers for all that debt. Imagine the effect on bulk wine prices if, for some reason, a big controlled appellation somewhere suddenly declassified all its wine and offered it out to the open bulk market – chaos. Will Lewis, the business editor of The Sunday Times, put it very succinctly in an editorial after a week of ruminating on the issue: “Some doubt whether the junk-bond market can subsume such a large quantity of debt. But all agree that these downgrades make life harder, rather than easier, for other companies reliant on low-grade debt.” And who, among those companies looking to snap up all or part of Allied, might they be? Err, all of them. No disrespect to them and their excellent managers, and again it is just an unfortunate sobriquet, but according to the world of corporate bond markets they are all junk. So, imagine a US-listed company wants to partner with a family-owned spirits company and make a joint bid for Allied; what does it have to do? It has to raise money, which might be a combination of issuing new shares in the new entity, borrowing money from investors in the form of bonds, and perhaps using some of its stockpile of cash. If it wants to make a cash offer to the shareholders of Allied, it will have to have the cash in place, and that means borrowing money, and perhaps a bond issue, for some or all of the ante. One bond market pro was sure of the outcome – more expensive borrowing, and probably a rethink about structuring any potential deal with more equity than they first planned. Certainly, the “more expensive” part looks likely. In order to catch the eye of the institutional investor who is himself looking with a glazed expression at US$450bn of carmaker debt, our would-be drinks conglomerate has to do something pretty special. In this arena, money talks. Suddenly, the cost of financing the deal is considerably more than all the bankers and lawyers thought it would be. It’s not like there wasn’t already trouble brewing in the drinks industry before the clouds from Detroit rolled over the debt market. According to a report in the finance website The Motley Fool, “Should either Constellation Brands or Fortune Brands win the bidding war for Allied Domecq, the ratings agencies have already communicated that their credit ratings are likely to be lowered, and, in turn, the cost of servicing their debt would increase.” One fund manager said in simple terms, the cost of financing such a deal, whether through bonds or any other type of borrowing, has probably risen by around one and a half percentage points – or, if the whole of the Allied bid were to be financed through debt, some £111m. A good indication of what might happen was seen with Allied’s bonds at the time of the announcement of the bid from Pernod. The Allied 2014 bond was trading at a 70 basis point premium to Libor, the inter-bank overnight lending rate, a widely-used comparative interest rate. When the deal was announced, the perception of higher risk carried by the bonds perhaps being payable by Pernod one day saw the premium shoot up to 190 basis points, or 1.9% (a basis point is one hundredth of one per cent). For the companies looking to table deals, talking to would-be lenders of money now is very different to when the original pursuer, Pernod/Fortune, started negotiations to structure their bid at the end of 2004. According to the bond fund manager, “There’s much more volatility, much more aversion to risk, and the starting point for price discussions [on financing deals] has changed.”