Carmakers’ Captives Show Reasons to Be Fearful

(Bloomberg Opinion) -- Bets on the world’s biggest car companies look a bit less safe as the U.S. market confronts slowing sales, an obsession with trucks and ballooning numbers of used cars.

Bonds of captive auto-finance companies like Ford Motor Credit Co., Toyota Motor Credit Corp., General Motors Financial Co. and Daimler AG’s financing subsidiary have been trading more like their parents in recent months. These units, essentially enablers of purchases by millions of consumers, have sold $78 billion of debt so far this year — the most in a decade for that period.

Meanwhile, the lowest-quality borrowers in the U.S. are defaulting on subprime loans — which constitute about one-fifth of auto lending since 2007 — at a faster clip than during the financial crisis, Fitch Ratings says. Yet investors seem complacent.

It’s time to reassess the carmaker halos around auto-finance bonds. True, delinquency rates for the highest-quality (prime) loans aren’t surging, but the weakening auto market could change that picture rapidly. Lenders had already started tightening standards last year. But more of the financing is now going toward used cars, prices of which are under pressure.

The captive finance companies account for anywhere from 65 percent to 90 percent of their parents’ debt burden, and a big part of how their securities are rated (and where they trade) is dependent on the owner’s rating.

That dependency isn’t a guarantee, though, and the benefit of big backers goes only so far. As the finance arms pile on debt, their fat margins are being compressed and revenue growth is fading. Interest costs continue to tick up with market rates, and the firms’ issuance of bigger chunks of more expensive, unsecured debt are coming home to bite. Loan losses have been rising.

A weaker market inundated with pre-owned cars has damped prices of all vehicles, and that’s reduced the residual value of auto leases. All of this has lowered the so-called fixed charge coverage ratio, a minimum relationship of Ebit to interest expenses that most captive finance companies must maintain to rely on support from their parents.

Take Toyota Motor Credit, the unit that helps boost Toyota Motor Corp. sales, especially in the U.S., the carmaker’s largest market. Equity investors seem to think all is well: The stock continued to rise after the May 9 earnings announcement, which focused on transformation into a broader mobility company, together with cost cutting. Look at the debt, however: Yields on Toyota Motor Credit bonds due 2021 have edged up to 3.2 percent since they were sold in mid-April at 2.9 percent, as have those on its other notes.

Sure, the Toyota unit’s asset quality is better than that of auto finance competitors. It manages more than $100 billion in leases and retail loans. Still, in the nine months through December 2017, operating margins dropped to 5.5 percent from 14.4 percent two years earlier. Then there’s the looming risk of lower residual values on leases and higher depreciation on used cars, plus a flood of off-lease vehicles coming to market over the next two years. Toyota is also the biggest seller of pre-owned cars in the U.S.

Moreover, Toyota Motor Credit, unlike many of its peers, remains heavily reliant on short-term debt like commercial paper. Such debt now accounts for almost 30 percent of the total, above the levels seen during the financial crisis. The proportion of unsecured liabilities, too, is the highest in the captive group — about 85 percent of its funding, according to Fitch Ratings.

Here’s another measure of stress: In good times, car companies rely on their finance units for dividends, as well as sales support. When times are bad, they pare back. And last year, Toyota Motor Credit didn't distribute a payout to its parent, Fitch Ratings analysts point out.

Captive credit is good until it isn’t. This might be the time for investors to switch off their cruise control.

©2018 Bloomberg L.P.

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