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GE Bondholders’ Fears Rekindled After Short Seller’s Report

Molly Smith
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GE Bondholders’ Fears Rekindled After Short Seller’s Report

(Bloomberg) -- A short-seller-funded report alleging accounting fraud at General Electric Co. has rekindled bondholders’ worst fears about the company, even if investors aren’t sure they buy the accusations.

GE’s most actively traded bonds have been clobbered over the last week, weakening the most since early February, after financial examiner Harry Markopolos raised questions about the money the company has set aside to cover insurance losses, among other issues. If there’s no merit to these charges, as GE says, the company still has to fix its ailing operations, while global economic growth is showing signs of weakening.

“The economy could have an outsized impact on a company that has yet to shore up its business plan. That’s where GE is,” said David Knutson, head of credit research for the Americas at Schroder Investment Management. “It still has a long way to go.”

The bonds’ weakness signals that investors are growing a little more worried not just about profits -- often the biggest concerns in the equity markets -- but also about the company’s ability to pay its bills. Risk premiums on GE’s notes are still generally lower than on junk bonds, suggesting that investors’ growing fears are still limited.

In late July, the company posted a 26% decline in operating earnings from its manufacturing units, and forecast free cash flow for the year which could be negative, although it did raise that projection from prior levels. As bond yields broadly fall, the company’s pension obligations could rise, forcing it to divert cash toward bulking up its retirement plans instead of paying off debt.

That alone should give investors pause, even if there is no merit to the report from Markopolos, who was early to raise concerns about fraudster Bernie Madoff, said analysts at CreditSights. GE Chief Executive Officer Larry Culp swiftly dismissed Markopolos’s report as “market manipulation -- pure and simple.”

“Although we have lots of qualms with Markopolos’ report, it does serve as a quasi wake-up call for investors,” the CreditSights analysts wrote in an Aug. 16 report. This year’s rally for GE debt “may have lulled the market into a false sense of security.”

Rally Fizzles

That’s showing up in the company’s debt. Risk premiums, or the extra yield a bond pays compared to Treasuries, have been widening for GE’s notes. Those spreads for GE Capital International Funding’s 4.418% bonds due November 2035, GE’s most actively traded security of the last 50 days, rose to 2.25 percentage points on Wednesday, from about 2.04 percentage points a week earlier before the report came out. Corporate bond spreads generally edged narrower over that period. The spread widening on GE’s 2035 bonds was the worst relative to the size of the risk premium since the week ended Feb. 8.

That weakness came after GE had been a bond market hero for much of the year. Spreads on the 2035 notes have narrowed significantly after starting 2019 at around 2.9 percentage points. GE notes offer higher yields than most other investment-grade securities, and the company has committed to paying down a chunk of its more than $108 billion of debt as it sells off assets.

So far this year, GE has sold part of its stake in Wabtec Corp., a railroad manufacturing and services company, and its bio-pharma business, amounting to more than $20 billion of additional cash that can be used to pay down debt. The company ended the second quarter with just under $30 billion of cash total at its industrial and capital units.

Downgrade Risk?

Markopolos said that the company’s high BBB credit rating will be cut once additional reserves for its long-term care unit are properly accounted for. So far, none of the three major credit raters have taken any action. Moody’s Investors Service and S&P Global Ratings have maintained a stable outlook, while that of Fitch Ratings is negative. (Fitch said in a Tuesday report that GE’s long-term care insurance reserves are worse than average, but did not change its rating on the company.)

Investors are trading the bonds as if they are at higher risk of being downgraded. The risk premium on an average BBB company bond is 1.52 percentage point, according to Bloomberg Barclays indexes. GE’s 5.55% bonds due 2026, which have a similar duration to the index, trade at a spread of around 2.11 percentage points, according to Trace.

Raters may ultimately succumb to “exhaustion” from defending rankings that can’t be supported by fundamental results, which could prompt them to take further negative action, Bloomberg Intelligence analyst Joel Levington said in a report Tuesday. However, GE benefits from rater expectations that are well below its peers, so staying close to its deleveraging goals could amount to limited rating risks, Levington said in a separate report.

GE is struggling to fix itself after having lost about half a trillion dollars in market value since peaking in 2000. In October, GE’s board ousted its chief executive officer and handed the reins to a turnaround expert: Larry Culp. Earlier this month the company said it’s in the middle of a “multiyear transformation.” It is trying to fix its power business while also showing signs of strain in its traditionally strong aviation unit.

“There has been a lot of faith put into the management team, particularly Culp, to turn around the ship from the direction it was going,” said Jody Lurie, a corporate credit analyst at Janney Montgomery Scott LLC. “The question is whether he’ll be successful.”

(Updates with cash flow forecast in fifth paragraph and asset dispositions in 10th.)

--With assistance from Richard Clough.

To contact the reporter on this story: Molly Smith in New York at msmith604@bloomberg.net

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Dan Wilchins, Christopher DeReza

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