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Junk Bonds in the Dead Zone

Written by Brian Hicks
Posted December 28, 2015

Welcome to the dead zone. 

It’s that time of year between religious holidays and the New Year where we’ve got a half-vacationing workforce and locked-down consumer purses. While America lazily fumbles its way toward the New Year, oil prices continue their slump through the days of low liquidity.

In December, the U.S. oil market saw reduced drilling, while international markets saw oversupply from Russia and OPEC. Developing markets, especially those in Asia, were slowing down at the same time. Brent crude has dropped about 65% from its high in June 2014, and it keeps sinking.

This is bad news, and we’ve been watching it slowly roll in all year. Saudi Arabia wants to force some U.S. oil companies into bankruptcy, and it looks like it’s going to work.

Think back a few years to when oil prices were climbing higher every day. U.S. oil and gas companies wanted to produce as much of that precious commodity as they could, so they sold bonds. At the same time, government bond yields were down and creeping toward record lows.

Investors began to consider the higher-risk, high-yield (“junk”) bonds being offered by these oil and gas companies. Domestic oil and gas held a lot of promise, and with the Fed holding the interest rate at zero, we watched the junk bond market to explode to nearly $2 trillion in size.

U.S. shale gas production drove global oil production, while the rest of the world saw a slight decline. But at the same time, Saudi Arabia was actually contributing to an oil oversupply and muscling the global price down.

Now, energy companies make up about 15% of the domestic junk bond market, and as oil prices fell globally, wouldn’t you know it — junk bond funds began to fall flat on their faces, too.

The downward pressure on oil prices meant those companies that went into debt to cash in on high oil were at greater risk of default. In early December, Standard & Poor’s Ratings Service put out the disquieting warning that half of the energy sector’s junk bonds were “distressed” and at risk of default.

That meant some $180 billion worth of debt was at risk of default. 

That much debt hadn’t been “distressed” since the Great Recession!

The odds began to favor a big number of energy defaults in 2016.

Then the first collapse happened: Third Avenue Management announced it was liquidating its six-year-old, $789 million high-yield fund, and investors were barred from withdrawing their capital.

Let’s be real, though. The fund that Third Avenue closed was actually kind of strange. Most junk bond funds have less than 5% of their assets in bonds that pay out 10% or more annually. Third Avenue’s Focused Credit Fund had HALF of its assets there. Almost 20% of its assets were illiquid level 3 assets.

If you’re not familiar with that type of asset, just know that mortgage-backed securities are of this kind. Their value is hard to determine, and there is no market price or model to give them measurable value.

It wasn’t a big fund, and it wasn’t typical, but it was a clear sign that the teeth of the corporate debt market had huge cavities after such a long bull run.

The following day, junk bond ETFs had their worst day in four years, and the whole sector was down more than 6%. More than 3% of that drop was in December alone, and it hasn’t even hit the bottom yet.

The Fed rate hike was mirrored by an interest rate hike in Saudi Arabia, and it’s not entirely certain how the bond market is going to weather it... but as we watch the price of oil continue to fall, the default risk rises.

Good investing,

Tim Conneally Sig

Tim Conneally

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