Ford Blazes Debt Trail

05/24/2011 8:00 am EST

Focus: BONDS

Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

The automaker’s drive for an investment-grade credit rating shows the sort of rectitude other borrowers lack, writes Marilyn Cohen, editor of Bond Smart Investor.

I have previously extolled the virtues of owning corporate bonds whose management is bond friendly. You don’t have to be a forensic accountant to understand what actions are and are not bond friendly. Here are six:

  • Special dividends paid for by issuing debt—not bond friendly
  • Increased dividend payments paid for by issuing debt—not bond friendly
  • Share repurchases done with existing cash and cash flow—not terrible, but not looking after us bondholders either
  • Share repurchases paid for by issuing new debt—not bond friendly
  • Takeovers paid for with cash and equity—not so pleasant for bondholders
  • Takeovers paid for by issuing new debt—not bond friendly

Then there are mutations of some of the above. As you pursue your quest to find bond-friendly corporate-management teams, watch for the pitfalls of hopping into bed with those that are not.

Ford Shows the Way
Ford (F), my pick for most bond-friendly management, shouted its mantra loud and clear. In mid-April, Ford announced the sale of $1.5 billion in asset-backed bonds. The assets backing these bonds are prime auto receivables. The bonds are called Ford Upgrade Exchange-Linked Notes—FUEL for short (so clever, these car guys).

The hook? Management’s message? These FUEL bonds will convert to straight corporate debt if Ford’s ratings reach investment grade. Specifically, if two of the three rating agencies—Standard & Poor's, Moody’s, or

Fitch—upgrade the asset-backed securities to investment grade.

The conversion would turn them into senior unsecured notes. Presently, unsecured Ford bonds are rated BB-. My only regret is that these FUEL bonds are a private-placement issue under Rule 144a for institutional investors only. Nevertheless, management is screaming about its goal of becoming investment grade again.

You can gauge how bond friendly a company has been each quarter by watching the amount of debt it has on its books. See if the cash flow pays down the revolving line of credit. Determine if it is being used to pay down bond debt while reducing the company leverage ratios. If the answer is yes, then you have a bond-friendly management.

NEXT: An Iron Mountain of Debt

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An Iron Mountain of Debt
There are instances when you must decide the severity of a company’s bond-unfriendly acts, and if you will tolerate it.

Here’s an example of one unfriendly bond move we won’t tolerate: Iron Mountain (IRM), the document-storage company that grew by acquisition, has recently caved into the pressures from Elliott Management, a hedge fund.

The hedge fund has been complaining about a lack of Iron Mountain’s shareholder value—this is the usual activist complaint. The CEO resigned and a committee is being formed to explore converting the company into a real estate investment trust (REIT).

The hedge fund owns less than 5% of Iron Mountain’s shares, yet it appears that their little threat has turned the entire board into scared rabbits. Iron Mountain’s plan is to return $1.2 billion to shareholders. This may include a big, fat one-time dividend, increased quarterly dividends, and share repurchases.

The cost, you ask? Probably around $2.2 billion. Standard & Poor's believes Iron Mountain will have to raise $2.2 billion in debt and draw from its revolver for this “financial extravaganza” (my characterization).

More leverage means a downgrade is coming. This unfriendly act forces us to issue a Sell recommendation on the bonds. Don’t wait.

Another Sell on our list is Arch Coal (ACI). Arch Coal announced it will buy International Coal (ICO). The amount is $3.4 billion, to be funded through the debt market.

We can presently get out of Arch Western Finance and Arch Coal bonds “slick” (meaning we’re even), wait for downgrades and new issues, and then re-evaluate their situation and credit metrics.

The “Fat Elvis” bond-friendly era has ended. Stay on top of your credits.

Cash on Hand a Muni Tell
Not much of the above is applicable to municipal bonds. However, you can glean the issuer’s cash balance from a look at the muni's financial statements. This usually identifies the number of days of cash it has on hand.

We’ve seen many large issuers have as much as 427 days of cash on hand. On the other hand, some shaky issuers may keep little or no cash on hand.

There’s no question which municipal bond issuers we prefer to own—those with the cash to pay us bondholders.

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