Downgrading the securities GM and Ford and their credit units to junk-bond status will affect just about every institutional investor because of the size of the two companies in the fixed-income market and their pervasiveness in investment portfolios.
Besides ordinary investment implications, active and passive fixed-income portfolios face more volatile trading on the two issuers because of Lehman Brothers Inc.'s change to its index inclusion rules, managers and fund executives said.
Standard & Poor's downgraded both General Motors Corp. and Ford Motor Co. securities to non-investment-grade status on May 5. That is leading Lehman to drop both companies from its investment-grade indexes June 1, when the indexes are rebalanced.
But the securities will reappear on the investment grade indexes July 1, when Lehman's modified index inclusion rules take effect. It added ratings from Fitch Rating Ltd. to its index list, alongside ratings of credit-rating agencies S&P and Moody's Investors Service, and as of July 1, Lehman will remove securities from its investment-grade lists only if two of the three credit-rating agencies have them at junk bond status.
Under rules in effect until July 1, the securities are removed only if either S&P or Moody's rates an issue to junk bond status.
"There are a fair amount of cross currents that could cause a lot of volatility" in the issues, said Greg Curran, director-index strategies, Standish Mellon Asset Management LLC, Pittsburgh. "There are going to be a number of portfolios that need to sell these out, not just indexers," because of quality limits on bond investments.
"Active managers and hedge funds will be looking to capitalize on whatever distress there is in the market," Mr. Curran added.
"The hedge fund community is pounding the heck out of these names," said Paula Horn, managing director-corporate and asset-backed securities, Deerfield Capital Management LLC, Chicago. They are seizing on the need of money managers to sell in compliance with investment-grade portfolio guidelines or in tracking the anticipated change in the Lehman indexes, said Ms. Horn, who manages a $3.5 billion corporate fixed-income portfolio.
"We have purchased some GMAC (General Motors Acceptance Corp. securities) at these distressed levels," she said. Her investment fund is already at its limit in Ford Motor Credit Co. securities.
Deerfield Capital's analysis shows GMAC and Ford Credit as good risks, in part because of their secured credit.
The Lehman change "is likely to impact a significant number of participants" in the market, said Matt Tucker, principal and head of the enhanced and index fixed-income strategy group at Barclays Global Investors, San Francisco. "It's a tremendous amount of market capitalization."
Lotsoff Capital Management, Chicago, which manages $400 million in active fixed income benchmarked to the Lehman investment grade index, won't be able to take advantage of any bargains in GM and Ford debt in June, said David A. Hershey, director of research and executive portfolio manager.
"According to our guidelines, we shouldn't buy them in June because they are out of the universe," said Mr. Hershey. "We'd be locked out in June. It's a small window."
"A lot of hedge funds are trying to take advantage by guessing who is going to drop out of the investment-grade universe," Mr. Hershey said. "So hedge funds short the bonds in anticipation of the downgrading," selling them through credit derivative swaps and then buying them back when they fall.
His portfolio lightened up on its GM and Ford exposure to below-index weighting before the announcement, he said.
"We aren't forced to sell in the event of a downgrading," Mr. Hershey said, referring to his portfolio policy discretion. "Nobody wants to sell in these distressed conditions."
At the $29 billion Alaska Permanent Fund Corp., Juneau, Richard Shafer, chief investment officer, said: "Eventually we would have to sell" GM and Ford bonds. The fund's guidelines don't permit it to hold non-investment-grade issues, he said.
"We have a long grace period (for selling). But under our guidelines, they have to be sold." He declined to say how long the grace period is.
The portfolio is now slightly overweight in GM bonds and slightly underweight in Ford bonds, Mr. Shafer said. He declined to give the amounts. The bonds are all with active managers, he said.
Mr. Shafer said he is concerned about selling the bonds in a market attuned to the trading intentions of public plans like the Alaska fund. Such publicity "is an open invitation for others to take advantage of us," he said.
Standish Mellon's Mr. Curran said the change in the Lehman indexes is big because GM and Ford "are two of the largest issuers in the index."
"Issues drop out all the time, but it is that these two are such large issues," he said.
On June 1, Lehman will remove $45.1 billion of GM and GMAC securities and $41.2 billion of Ford and Ford Motor Credit Co. securities, said Carrie Cohen, Lehman spokeswoman. The GM and Ford issues amount to, respectively, 2.02% and 1.97% of the Lehman Corporate Credit index and 0.49% and 0.47% of its Aggregate index.
As they fall out of the Lehman Aggregate index June 1, most of the GM and Ford securities —some $87 billion — will move to the Lehman High-Yield index, she said.
Ford and GM would make up about 6.4% and 5.9%, respectively, of the high-yield index, depending on their market values, noted Lance Berg, spokesman at Barclays Global Investors, San Francisco.
But on July 1, when Lehman's new index inclusion rule takes effect, Lehman will restore GM and Ford securities to its aggregate index and other investment-grade indexes — unless Moody's or Fitch Rating Ltd. also downgrades GM or Ford to below-investment-grade status.
Moody's downgraded both Ford and Ford Credit May 12. It cut Ford to its lowest investment-grade rating and Ford Credit to its second lowest investment-grade rating.
The $49.3 billion State of Michigan Retirement System, Lansing, won't buy any more GM or Ford bonds or notes, so long as they are rated non-investment grade, because guidelines prohibit holding non-investment-grade issues, although the guidelines don't require the fund to sell those securities it already owns, said Terry Stanton, public information officer.
In bonds and notes, the system has $29.4 million in GM, $221.6 million in GMAC and $190 million in Ford Credit, mostly managed internally, he said.
Standish Mellon intends to track the index changes, selling its GM and Ford holdings in its Lehman index funds for the June 1 rebalancing and then buying them back to conform to the July 1 index, Mr. Curran said.
Standish Mellon has $11.3 billion in fixed-income indexes, 90% of which is in Lehman strategies, he said. "If we don't sell them, we'd run the risk of tracking error," Mr. Curran said. "How we will trade them is a strategy we are developing," to minimize costs, he said.
"We've had a universal response (from clients that) they don't want us to hold non-index issues," he added.
At Vanguard Group, Malvern, Pa., Michael J. Smith, spokesman, said, "We will mirror the benchmark and sell those two securities."
Vanguard has $35 billion in Lehman Aggregate index funds, he said.
