Junk-Bond Worries Spread Beyond Oil A Pullback From Junk Bonds Can Be Harbinger That Risk Is Being Reassessed

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The oil bust is exposing cracks in the $1.3 trillion junk-bond market, putting pressure on a key source of corporate financing and potentially crimping economic growth.

U.S. junk-bond prices have fallen 8% since late June, according to data from Barclays PLC. One-third of that drop has come this month alone, putting the market on track for its worst annual performance since the financial crisis.

While much of the stress has been in the energy sector on the heels of the sharp decline in oil prices, lately the woe is spreading across the junk market.

Each of the 21 high-yield sectors in a U.S. junk-bond index tracked by J.P. Morgan Chase & Co. registered losses in the five days ended Dec. 9.

“Oil prices have crushed the energy sector and it’s leaking elsewhere,” said Andrew Herenstein, co-founder of Monarch Alternative Capital LP, which manages $5 billion and is among the largest investors in distressed debt.

Debt is generally deemed to be distressed when investors view it as at high risk of missing bond payments or of a restructuring, at least at some point.

A pullback from junk bonds is often a harbinger of a broader reassessment of risk across financial markets, raising the possibility that investors could turn more wary of stocks and other assets.

Skeptics warned earlier this year that the junk market was becoming overheated, pointing to the risk of a larger-than-expected retreat.

A raft of postcrisis rules have hit securities-dealing banks, hampering the ability of those middlemen to cushion a selloff, especially in risky assets. Many say the changing role of those dealers is exaggerating the price drops, raising the risk of indiscriminate selling, or “fire sales.”

“The problem with high yield is often that investors have to sell what they can, not what they want to,” said Peter Tchir, managing director at Brean Capital LLC, an investment bank and asset manager.

The junk selloff comes as investors are uneasy about the global economy and Federal Reserve interest-rate increases that many expect to begin next year.

Junk bonds, like stocks, have mostly proved resilient, bouncing back after modest pullbacks. Both these bonds, and stocks, could again resist a deep drop.

But some are betting this current junk-bond decline will deepen, if investors are caught off guard by a slowdown in growth, a corresponding rise in defaults and dealer difficulty in absorbing all the selling.

Joshua Birnbaum, the ex-Goldman Sachs Group Inc. trader who made bets against subprime mortgages during the financial crisis, now has more than $2 billion in wagers against high-yield bonds at his Tilden Park Capital Management LP hedge-fund firm, according to investor documents.

Some investors worry the selling could feed on itself, sending up yields, stalling issuance and prompting restructurings or bankruptcies, analysts said.

Weakening demand for junk bonds has investors demanding a more generous yield to purchase these bonds rather than safer debt. Junk bonds now trade at a yield of 5.28 percentage points above yields of comparable U.S. Treasurys, up from 3.23 points at their June low for the year.

Investors’ “panicky logic” also includes some “nervousness” ahead of a meeting this week when the Fed may provide updated signals on interest rates, said Anthony Valeri, investment strategist at LPL Financial, which directly oversees or advises on $415 billion of assets.

U.S. high-yield bonds have returned just 0.78% this year, including price action and dividends, according to Barclays, putting the debt on track for its worst showing since 2008. Junk bonds returned 7.44% last year and 15.8% in 2012, Barclays said.

Since June, investors have yanked more than $22 billion from funds dedicated to junk bonds, according to fund tracker Lipper. Investors withdrew an additional $1.9 billion in the latest week ended Wednesday.

To be sure, the factors that have supported the junk-market rally since 2009 remain largely in place. The U.S. economy is growing, with job creation expanding last month at the fastest clip since the tech boom of the late 1990s, and interest rates and defaults remain low. Despite the issuance slowdown, financing remains broadly available and defaults are low.

What’s more, high-returning investments remain scarce amid low yields on safer bonds, meaning that many investors retain the “reach for yield” mentality that favors risk taking in income-generating securities.

“These bonds have been beaten up tremendously and they’re not all going to default,” said Brendan Dillon, senior investment manager at Aberdeen Asset Management Inc. Mr. Dillon said he has added 1% to 2% to the firm’s energy exposure within its high-yield funds because those bonds were oversold. Still, traders are scurrying to reposition.

Daily high-yield trading volumes earlier this month reached an average of $8.2 billion, said J.P. Morgan, just shy of their October record and up from the daily average of $5.6 billion in 2013.

Junk-bond issuance has slowed. Companies such as Dallas refiner Alon USA Energy Inc. have pulled deals. Units of casino and resorts operator Parq Holdings LP and food and beverage giant JBS USA also canceled planned bond sales this month, according to Leveraged Commentary & Data.

JBS didn’t respond to a request for comment. Parq had no comment.

Still, some see a buying opportunity at hand. Investors will “try to sell all or a lot of their energy holdings somewhat indiscriminately…and when the dust settles some investors have an opportunity,” said David Breazzano, chief investment officer at money manager DDJ Capital Management LLC, which oversees about $8 billion.

—Matt Wirz contributed to this article.

Write to Katy Burne at katy.burne@wsj.com, Gregory Zuckerman at gregory.zuckerman@wsj.com and Rob Copeland at rob.copeland@wsj.com

 

 

Fed Bubble Bursts in $550 Billion of Energy Debt: Credit Markets By Christine Idzelis and Craig Torres – Dec 11, 2014, 10:59:52 AM

The danger of stimulus-induced bubbles is starting to play out in the market for energy-company debt.

Since early 2010, energy producers have raised $550 billion of new bonds and loans as the Federal Reserve held borrowing costs near zero, according to Deutsche Bank AG. With oil prices plunging, investors are questioning the ability of some issuers to meet their debt obligations. Research firm CreditSights Inc. predicts the default rate for energy junk bonds will double to eight percent next year.

“Anything that becomes a mania — it ends badly,” said Tim Gramatovich, who helps manage more than $800 million as chief investment officer of Santa Barbara, California-based Peritus Asset Management. “And this is a mania.”

The Fed’s decision to keep benchmark interest rates at record lows for six years has encouraged investors to funnel cash into speculative-grade securities to generate returns, raising concern that risks were being overlooked. A report from Moody’s Investors Service this week found that investor protections in corporate debt are at an all-time low, while average yields on junk bonds were recently lower than what investment-grade companies were paying before the credit crisis.

Borrowing costs for energy companies have skyrocketed in the past six months as West Texas Intermediate crude, the U.S. benchmark, has dropped 44 percent to $60.46 a barrel since reaching this year’s peak of $107.26 in June.

Yields Surge

Yields on junk-rated energy bonds climbed to a more-than-five-year high of 9.5 percent this week from 5.7 percent in June, according to Bank of America Merrill Lynch index data. At least three energy-related borrowers, including C&J Energy Services Inc. (CJES ▼ -3.13% 12.07), postponed financings this month as sentiment soured.

“It’s been super cheap” for energy companies to obtain financing over the past five years, said Brian Gibbons, a senior analyst for oil and gas at CreditSights in New York. Now, companies with ratings of B or below are “virtually shut out of the market” and will have to “rely on a combination of asset sales” and their credit lines, he said.

Companies rated Ba1 and lower by Moody’s and BB+ and below by Standard & Poor’s are considered speculative grade.

Stimulus Effect

The Fed’s three rounds of bond buying were a gift to small companies in the capital-intensive energy industry that needed cheap borrowing costs to thrive, according to Chris Lafakis, a senior economist at Moody’s Analytics in West Chester, Pennsylvania.

Quantitative easing “has been one of the keys to the fast, breakneck pace of the growth in U.S. oil production which requires abundant capital,” Lafakis said.

One of those to take advantage was Energy XXI Ltd. (EXXI ▼ -1.39% 2.84), an oil and gas explorer, which has raised more than $2 billion in the bond market in the past four years.

The Houston-based company’s $750 million of 9.25 percent notes, issued in December 2010, have tumbled to 64 cents on the dollar from 106.3 cents in September, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. They yield 27.7 percent.

Energy XXI got its lenders in August to waive a potential violation of its credit agreement because its debt had risen relative to its earnings, according to a regulatory filing. In September, lenders agreed to increase the amount of leverage allowed.

Bubble Risk

“We think the sell-off has been a little over done,” said Greg Smith, a vice president in Energy XXI’s investor relations department. “People are trading us as though we’re distressed.”

The company has “plenty of liquidity,” Smith said. “Come January we’ll be free cash flow positive,” which is “a rarity in this business,” he said.

The debt rout is one of the latest examples of a boom and bust in U.S. markets as unprecedented Fed stimulus fuels a hunt for yield. The fallout has been limited so far, yet the longer the Fed holds its benchmark lending rate near zero, the greater the risk of more consequential bubbles, according to former Fed governor Jeremy Stein.

“To the extent that highly accommodative monetary policy courts risks to the economy further down the road, there is more of a live trade-off than there was at 8 percent unemployment” said Stein, now a Harvard University professor.

Joblessness of 5.8 percent in November was about half a percentage point away from the Fed’s estimate of full employment, or the lowest level of labor market slack the economy can sustain before companies bid up wages.

Job Creation

Employment in support services for oil and gas operations has surged 70 percent since the U.S. expansion began in June 2009, while oil and gas extraction payrolls have climbed 34 percent.

“There are distortions in multiple markets,” said Lawrence Goodman, president of the Center for Financial Stability, a monetary research group in New York. “It is like a Whac-A-Mole game: You don’t know where it is going to pop up next.”

Fed Chair Janet Yellen said in a July 2 speech in Washington that she saw “pockets of increased risk-taking,” including in the corporate debt markets.

Midstates Petroleum Co. (MPO ▼ -11.56% 1.30) is spending about $1.15 drilling for every dollar earned selling oil and gas. Outspending cash flow is the norm for many companies in the U.S. shale boom.

Changing Environment

The Houston-based company’s $700 million of 9.25 percent notes due in June 2021 have plummeted to 53.5 cents from 108 cents at the beginning of September, according to Trace. The debt is rated Caa1 by Moody’s and B- by S&P.

Representatives of Midstates didn’t respond to phone calls and e-mails seeking comment.

Some borrowers are under pressure just a few months after selling new debt. Sanchez Energy Corp.’s $1.15 billion of 6.125 percent notes maturing in January 2023, issued this year, have tumbled to 77 cents from 101 cents in September, according to Trace. Proceeds from the bonds were partly used to fund a purchase of Eagle Ford shale assets from Royal Dutch Shell Plc. (RDSA ▲ 0.78% 25.97)

“The company has planned for and is poised to rapidly adapt to a changing commodity price environment,” Tony Sanchez, III, chief executive officer of Sanchez Energy, said in a statement yesterday.

The Houston-based company expects to fully fund its 2015 capital program from operating cash flow and cash on hand without drawing on its revolving credit line, the statement said.

Magnum Hunter

Sanchez Energy has never had positive free cash flow. Michael Long, chief financial officer, didn’t return a call seeking comment.

“Oil companies that have high funding costs in the Eagle Ford and the Bakken shale plays are the ones that are most exposed right now due to lower crude prices,” Gary C. Evans, chief executive officer of Magnum Hunter Resources (MHR ▼ -4.16% 3.46) Corp., said in a phone interview.

Magnum Hunter’s $600 million of 9.75 percent debt due in 2020 has tumbled to 84.5 cents from 109 cents in September, Trace data show. The notes are rated CCC by S&P and yield 13.9 percent.

Evans said Houston-based Magnum Hunter sold almost all of its oil properties over the last year and a half and is now predominantly a gas company.

Default Risk

“We’ve insulated ourselves,” Evans said. For other energy borrowers at risk, “the liquidity squeeze” will probably occur in March or April when banks re-calculate have much they may borrow under their credit lines based on the value of their oil reserves.

Deutsche Bank analysts predicted in a Dec. 8 report that about a third of companies rated B or CCC may be unable to meet their obligations should oil prices drop to $55 a barrel.

“If you keep oil prices low enough for long enough, there is a pretty good case that some of the weakest issuers in the high-yield space will run into cash-flow issues,” Oleg Melentyev, a New York-based credit strategist at Deutsche Bank, said in a telephone interview.

For Related News and Information: Junk Fervor Cools as Oil Rout Upends Energy Debt: Credit Markets Junk Backing Shale Boom Faces $11.6 Billion Loss: Credit Markets Shale Boom’s Allure to Wall Street Tested by Drop in Oil Prices Oil Slump Heaps Bond Losses in $50 Billion Glut: Credit Markets Drillers Piling Up More Debt Than Oil Hunting Fortunes in Shale

To contact the reporters on this story: Christine Idzelis in New York at cidzelis@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Caroline Salas Gage, Faris Khan