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:

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.

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