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WORLD BONDS-Auto sell-off could derail corporate debt rally

By Catherine Evans

LONDON, Oct 22 (Reuters) - A year-long rally in corporate bonds could be derailed by growing worries about credit quality among the world's leading automakers, highlighted by negative credit rating moves and soaring spreads in the sector this week.

Bonds of the "Big 3" auto firms have fallen sharply in value since Tuesday, when credit rating agency Standard & Poor's surprised financial markets by cutting DaimlerChrysler and said it might also downgrade Ford Motor Co .

The sell-off hit the wider corporate bond market, of which auto debt accounts for roughly one-third in Europe. The Big 3 account for some six percent of the market by outstanding volume in the U.S..

Further weakening is possible, analysts said, especially if S&P cuts Ford's rating to BBB-, just one notch above "junk" grade, and retains a negative outlook. That could trigger precautionary selling by investors unable to hold sub-investment grade rated debt.

"Although that should be the extent of the action in the short term, investors will clearly have to address the issue of what happens next to $180 billion of (Ford) debt teetering perilously close to what remains no-go territory for a large part of the investment community," said credit analysts at ABN AMRO in a research note on Wednesday.

"Clearly, any rebalancing has the potential to impact the wider market."

Corporate bonds have undergone a massive rally this year. The average yield on investment-grade corporate bonds in euros, as measured by the FTSE Euro Corporate Bond Index, has fallen to around 70 basis points more than low-risk government debt, close to historic lows, from over 180 basis points in October 2002.

Then, corporate bond spreads touched their highest-ever levels as a stumbling global economy and the threat of war in Iraq exacerbated concerns about corporate indebtedness, especially among Europe's highly-leveraged telecom operators.

Long-delayed moves by companies such as France Telecom and Deutsche Telekom to tackle their mountainous debts -- by raising new equity, cutting costs and selling assets -- were a key trigger for this year's rally.

Previous failures to meet debt deleveraging targets had triggered a string of credit rating downgrades, with 55 percent state-owned France Telecom slashed to just above "junk" grade.

DOWNGRADES

Automakers have also been subject to a string of downgrades, with rating agencies citing worries about weakening demand, especially in the highly competitive North American market, and underfunded pension liabilities.

On Tuesday, S&P downgraded DaimlerChrysler, the world's fifth-largest automaker, by one notch to BBB, its second-lowest investment-grade rating, and assigned a negative outlook, meaning the rating could be cut again.

It put world No. 2 Ford Motor Co's BBB rating under review for a possible downgrade, but said it did not expect to cut the firm to "junk" grade, and affirmed its BBB rating with a negative outlook for market leader General Motors .

Ford's 5.75 percent euro bond due January 2009 was quoted about 36 basis points wider in early trading on Wednesday, at around 232 basis points over swaps. DaimlerChrysler and GM bonds also widened, although corporate debt as a whole was little moved.

"There is some evidence that real money accounts are beginning to sell Ford, but we aren't seeing client activity in other sectors or even other auto names. The street is marking paper wider, which is what we have seen in the past two years during periods of volatility," said Suki Mann, credit strategist at Societe Generale.

"That said, if Ford is cut to BBB- with a negative outlook, we will see forced sellers, and that will have a knock-on effect on the wider market."

Analysts' views on the DaimlerChrysler downgrade itself were mixed, although several expressed surprise that S&P now ranked the firm in line with GM, at BBB with a negative outlook.

"Considering DaimlerChrysler's considerably lower leverage, wider product mix, and strong Mercedes brand, we find this hard to understand," said credit analysts at SE Merchant Banking.

"In our opinion, this should mean that GM's ratings likely will be lowered by S&P within the coming quarters."

SE recommended investors underweight the auto sector in their portfolios. Credit analysts at Barclays Capital took a different view, however, advising investors to overweight autos, snapping up cheap paper during the current sell-off.

They said their shift in stance was "not a fundamental credit call", however, "but more of a portfolio management call, as S&P's actions essentially eliminate the risk of any further material rating actions for the sector until mid-January at the earliest".

--Additional reporting by David Wigan and Bei-Bei She in London and Dena Aubin in New York