Deutsche says sell Fiat exchangeables into GM on recent richening as rating review ignites concern

By Ronda Fears

Nashville, Tenn., March 5 - The recent decision by Moody's Investors Service to place Fiat on review for possible downgrade has focused investors' attention on the terms of Fiat Finance's 3.25% exchangeable due 2007, which converts into General Motors Corp. stock, where there is considerable cause for concern, said Deutsche Banc Alex. Brown convertible analysts in a report Tuesday. The issue is trading at a discount to GM's new convertibles, the analysts said, but recent richening is an opportunity to sell.

Last week, Moody's placed the Baa2 long-term and Prime-2 short-term ratings of entities guaranteed by Fiat on review for possible downgrade, including Fiat Finance.

"If downgraded, Fiat would lose access to the commercial paper markets. This would be a genuine problem for the company. One more downgrade could see Fiat expelled from the commercial paper market," said Deutsche analysts Jeremy Howard and Jonathan Cohen in the report. The analysts noted that credit default swap levels in Fiat have nearly doubled from 180 basis points over Libor to 340 basis points in recent weeks.

Moreover, the analysts said holders of the Fiat/GM issue are poorly protected and the credit concerns related to Fiat have depressed the bond's value. And, the report states, recent richening in the issue offers opportunity to sell.

"We do feel that the current credit concerns surrounding Fiat at this time are a serious problem for the bond's valuation; and we also feel that too many of the marginal provisions of the prospectus appear to have been structured with the issuer's, rather than the investor's, interests in mind," the analysts said.

Concerns about the Fiat/GM exchangeable are related to bondholder protection in a bankruptcy scenario, issuer-tilted conversion options, weak dividend protection, poor provisions concerning passthrough cash that Fiat might receive for GM shares in the event of a merger and what's referred to as an issuer "screw" clause.

"To cap it all, the Fiat/GM 3.25% 2007 prospectus states that in the event of exchange (conversion) the bonds will cease to bear interest from the interest payment date immediately preceding the exchange," the analysts said.

"This is a 'screw clause' because the right to exchange expires 10 business days prior to the maturity date, and so the final coupon of 1.625 points would appear to be lost on conversion."

Lack of bondholder protection was a common theme among the concerns.

Having no bankruptcy-remote vehicle holding the GM shares underlying the convertible creates danger in the event of a liquidation of Fiat assets, the analysts said, and the prospectus is very clear that the GM shares underlying the bond are in no way secured for the benefit of bondholders. "Our reading (and we do not feel this can be contested) of this clause is that if Fiat were in a liquidation scenario the exchange property would simply form part of the unsecured asset pool to be liquidated to pay creditors.

"This creates a potentially huge problem for outright and especially hedged holders of the exchangeable," the analysts said.

"They could find themselves in a position where parity had risen significantly but because of a liquidation of Fiat the shares were not delivered to converting bondholders. In an extreme scenario, this could create a huge problem for arbitrage funds that could be short GM shares that had risen substantially but unable to convert."

Price: 97.5

Parity: 79.05

Premium: 23.34%

YTM: 3.819%

YTP: 4.378%

Next Put: July 9, 2004

Next Call: N/A

Credit Spread: L+375bps

Bond Floor: 90.52

Implied Volatility: 24.52%

Historical Volatility: 32.00%

Delta: 45.05%

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