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To keep or not keep GM bonds

Dr. Don TaylorDear Dr. Don,
I have long-term bonds with GM that pay between 6.5 percent and 8.25 percent and go out 20 and 25 years. These investments were to generate retirement income and amount to about 8 percent of our holdings. With all the bad GM press recently, it has been suggested that we take the loss and get out. What are your thoughts concerning that? Thanks.
-- Doug Diminished

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Dear Doug,
Tough call. There isn't a definitive answer. I'll try to help you find the answer that is right for you. First, recognize that there is a difference between GM bonds and GMAC bonds. It's possible that General Motors Acceptance Corporation (GMAC) could be spun off and continue on its own as an investment-grade finance company. Since you said you own GM bonds, I'll limit my discussion to GM Corporation bonds.

Corporate bonds trade at a spread to U.S. Treasury securities based on the corporate bond's credit risk as measured by one of the rating agencies. The big three credit rating agencies are Fitch IBCA, Moody's and Standard & Poor's. The ratings classifications differ between these companies, but the idea of classifying credit risk is the same. For convenience, I'll use Standard & Poor's ratings classifications here.

The highest credit rating is AAA. Bonds rated from BBB to AAA are considered investment grade. Bonds rated below investment grade, BB or lower but not in default, are "high yield" bonds. Bonds that were originally issued at investment grade and later downgraded to non-investment grade status are called "fallen angels."

GM bonds at this writing continue to have an investment-grade rating, but are trading at spreads to U.S. Treasuries that are wider than the spreads on most "high yield" corporate bonds. It is very common for an issuer tainted with headline risk to trade at much wider spreads than lower-rated credits.

An argument against selling is that the increased credit risk is already priced into the bonds and you might as well hold on, hoping to avoid recognizing the losses as GM takes steps to improve its profitability and credit rating. GM isn't expected to burn through its cash stockpiles in the near term, so there's not an immediate need to act. You bought the bonds for income and there's no reason to expect that income will cease any time soon.

An argument for selling these bonds is that GM is holding on to an investment-grade credit rating by its fingertips and, since bond ratings tend to lag financial results, more bad news is possible, triggering another sell-off. If GM loses its investment-grade credit rating, any portfolio managers that still own the name and are limited to investing in investment-grade debt will have to sell the bonds, pushing GM bond prices even lower. This argument has you taking your licks now and moving on.

If you decide to sell the bonds, you should work with your investment professional and tax adviser to manage the tax impact of the sale and to find appropriate replacements for these securities in your portfolio. Your letter reads like you were chasing yield and got burned. Look to diversify your holdings away from a point where you're holding 8 percent of your wealth in any one company.

It doesn't have to be all or none. You can dial down the risk by eventually selling some of the bonds. Assuming that the bonds were purchased close to par, the sale of the higher-coupon bonds would minimize the current principal loss.

Note: A thanks and a tip of the hat to Jeff Matthias, a bond portfolio manager for American Family Mutual Insurance Company in Madison, Wisc., for his help in understanding the credit issues and current markets in these bonds.

 
-- Posted: April 8, 2005
     

 

 
 

 

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