These 4 Junk Stocks Are on Their Way Up

When it comes to predicting the end of the housing bubble, ratings agencies did just about the worst job imaginable. But the bond market still pays plenty of attention to company bond ratings, and the impact of an upgrade or downgrade can make a huge difference to a company's bottom line.

Why bother with ratings?
After the mortgage-backed-securities debacle of 2008, you might think that no one would be paying much attention to bond ratings anymore. After all, when a whole bunch of AAA-rated debt starts going belly-up, it calls into question the entire ratings system. Even Warren Buffett, who has made significant investments in Moody's (NYSE: MCO  ) , conceded that ratings agencies made huge mistakes in evaluating collateralized debt obligations tied to mortgages.

Nevertheless, ratings still hold a lot of weight among bond investors, and no distinction is more important than whether a company's debt qualifies for an investment-grade rating. Being able to escape high-yield "junk" status is a major accomplishment for a company, and it's one that can bring with it huge cost savings and a bump for its stock.

Less junk, more profit
Because that line between BBB- and BB+ is so huge, it's worth looking at companies that are straddling that line. According to Fitch Research, the number of investment-grade companies at risk of falling to junk status fell from 15 last September to just four. Of the 11 companies that fell off the list, only one actually dropped to a junk rating; the others were judged not to have any further risk of a downgrade.

Even more promisingly, the report identified four companies that currently have junk ratings from Fitch but also have positive ratings outlooks for the future. They are Del Monte Foods (NYSE: DLM  ) , Flowserve (NYSE: FLS  ) , Interpublic Group (NYSE: IPG  ) , and Jabil Circuit (NYSE: JBL  ) .

Just a single tick in a bond rating makes a huge difference to financing costs. Currently, spreads on BB+ rated bonds are typically more than a percentage point higher than BBB- rated bonds. Here's a closer look at just how big a difference that could make to these companies:

Company

Annual Savings From 1 Percentage-Point Reduction in Interest Costs

Del Monte Foods

$12.9 million

Flowserve

$5.7 million

Interpublic Group

$19.4 million

Jabil Circuit

$12.0 million

Source: Yahoo! Finance.

That may not sound like much, especially when you realize that those savings translate to just pennies per share. But for Interpublic Group and Jabil Circuit in particular, those pennies would create a noticeable boost in earnings over the past 12 months.

Of course, investors in those companies' bonds will see the most immediate move. If existing bonds see their spreads compress to investment-grade levels, then bondholders should see an immediate capital gain on the bonds they own. That in turn may drive further demand for those bonds, giving the companies a unique opportunity to refinance their debt at lower rates.

Going down?
On the other hand, the four companies still on the list for potential downgrades face the opposite problem. With Alcoa (NYSE: AA  ) , Convergys, Macy's, and Motorola (NYSE: MOT  ) all having negative outlooks for their BBB- ratings, refinancing debt may get a lot more difficult in the near future. Moreover, Alcoa, Macy's, and Motorola all have pretty big debt loads, so paying an extra percentage point in interest could well be enough to create a noticeable dent on their finances. In addition, once-burned bond investors will be twice shy about buying new debt.

One lesson you should have learned from the financial crisis is that even though investors own different types of assets for diversification purposes, you can still glean valuable information from one market that will affect others. Bond investors will see the most immediate impact from an upgrade from or downgrade to junk status, but such moves can also have an effect on stocks. Realizing that such a move may be coming can help you prepare for a potentially profitable investing opportunity.

Don't settle for less than the best. Tim Hanson shows you how you can make your best investment ever.

Fool contributor Dan Caplinger likes looking through junk in search of a diamond in the rough. He doesn't own shares of the companies mentioned in this article. Motley Fool Options has recommended writing puts on Moody's, which is a Motley Fool Inside Value pick and a Motley Fool Stock Advisor choice. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is movin' on up to a deluxe apartment in the sky.


Read/Post Comments (1) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 16, 2010, at 1:08 PM, inastrangeland wrote:

    I have a lot of respect for the fool community but in this case, Dan has clearly not done his homework. Saying that Motorola has a heavy debt load completely ignores the facts. The fact is, Motorola has 3.9B in debt and over 8B in cash. They have also announced a debt reduction program which recently retired $200M in debt and has a goal of $500M in debt reduction. This is nothing close to being a heavy debt load. Please do your homework before writing articles that ignore reality.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1209976, ~/Articles/ArticleHandler.aspx, 11/25/2014 4:10:56 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement