Junk Bond Default?
Junk bonds fall hard these days (check JNK). Some analysts believe this merely reflects current oil price drop. Price will recover once oil price recovery which should happen soon. Even if not, this junk bond default is “well contained”. Some analysts pointed to the 2007 subprime crisis – initially, Fed and Treasury told people it was “well contained”. Let’s think about this:
1. JNK peaked in last June, together with recent oil price peak (although post 2007 oil peaked happened in May, 2011, steep drop started last June)
2. Spread between junk bond (JNK) and Treasury (IEI, IEF, TLT) widening, so does spread with investment corporate bonds (LQD)
3. If oil price bottom here and rise sharply, JNK issue should cure and we should stop here
4. But, let’s check BDI and other industry metals (copper, iron ole, …), they all falling hard
5. Look at BDI, it is below 1000. Under this price, most running lose even with lower oil price; companies cut price due to low demand or input price drop?
6. From BDI and industry metals, demand collapse is a better explanation of recent oil price drop
7. If so, will junk bond trouble from energy companies trigger a larger crisis?
8. We need to think internationally, not just domestically – junk bond prices also fall in Europe plus Greek government bonds get into trouble again
9. Back to USA, who own junk bonds – not directly owned by most retail investors, pension funds, insurance companies, commercial banks, … (could indirectly owned as some own hedge funds). Bingo! hedge funds are big owners, not just own all right but on margin
10. Will a few hedge funds’ unwinding trigger others’ stop loss and lead some into bankruptcy? (two hedge funds specialized in subprime CDO went bust a couple of months before stock index’ 2007 top)
11. As we saw, after Greek bonds went into trouble, people suddenly started looking around other government bonds and say PII*S also in trouble then you know
12. Back to US, will people look around junk bonds in other sectors saying they are also in trouble
13. If junk bonds issue ballooning and many ownership is on margin (hedge funds), how can it unwind peacefully?
14, You can stay in 30 feet deep water without breathe for 1 minute but not immerge your face in an one foot deep bucket for 10 minutes. Same applies to US shale energy companies as they can stand for short period of severe oil price drop but not prolonged slump on oil price.
It is pretty long now. Let’s think more and then write.
15. So, if oil price just stays here for a few months (worse, if drop), we should see first wave of junk bond default
16. Forget not, shale energy junk bond yield ~5.6% around their last June top, now is far higher
17. We need to consider ripple effects, not just shale companies belly up and hedge funds bankrupt
18. Key question, will people react like subprime? looked beyond subprime (expand into alt-A, etc.) and started worrying all mortgage CDO even good ones.
Energy companies junk bonds is ~18% of total US junk bond issuance (~1.3 trillion), far exceed the 2nd largest sector health care (~7%). No, need falls further, oil price just keep here even allow some rebound, many US shale energy companies will default. Just as stated in item 14, you can stay in 30 feet deep water for 1 minute but not immerse your face in 1 foot deep water for 1 hour.
Let's continue discussion:
19. This phase oil price drop came suddenly (started steep falling last June). Although post 2007 oil price top was in May 2011, oil price remain high for two years (basically side way)
20. Shale energy companies can stand for a few months but not a couple of years
21. Drilling permit already plunged
22. Yes, many businesses support drilling will suddenly see their business evaporate
23. But our key focus remain – will this junk default generate enough ripple effects
24. Basically, junk bonds are separated into two categories – falling stars (used to be good companies) and rising stars (new startup). Apparently, many treat shale energy companies as the later
25. While invest in junk bond of rising stars, people worry less on default than falling stars
26. As hedge funds are major holders, they own them on margin to deliver stellar return
27. I doubt they can unwind peacefully. Forget not, general mood would explode if government bails out junk bonds,
28. If some cannot unwind peacefully and banks start margin call but found sale of those junk bonds could NOT cover all loans, will ….
29. Will banks running scared and start looking on other junk bonds and risk assets
30. We know how subprime crisis was ballooned. so did Europe sovereign debt crisis
31. Forget not, now, on one hand, US federal government encourages banks to make loans; on the other hand, strict laws been set to punish them if lending turn sour (OK, stated as if they make loans without prudent judgment)
32. So, any slight hint banks may be prosecuted due to lend to hedge funds to speculate in junk bonds could trigger a massive credit withdraw to kill even still stable bonds
33. Will this hurt overall corporate bond market?
34. Many companies now issue corporate bonds for stock buyback, will this dry up?
35. As we cannot just consider domestically, also need to consider foreigners who hold US assets
36. As claimed, Saudi Arabia has 3 years of reserve thus can withstand low oil price – my question is what assets in this so called reserve? how big portion is in US financial assets? in order to get money to run their government programs, will they sell US assets?
To be continued
Low oil price is not good for USA as shale oil/gas industry is in heavy capital spending. If oil price stays low (even if rebound a bit from here), we should see massive junk bond default. If I see hedge funds bankrupt, I will not listen to Fed nor the administration. I am afraid a junk default leads to US market collapse.
Fed raised interest rate in 1931, during the 1929-32 market crash. Fed was NOT insane. At that time, sovereign defaults ran in Europe. People started thinking possibility of US default thus Fed had no choice but raise rate. We will see what Fed will do – it is one thing as you are conservative or liberal; it is another thing that you are forced to save #@#%%! without choice.
This low oil price is NOT from plenty of supply but demand collapse. Now, it happens in Europe, etc. areas outside USA. Sooner or later, it will come to USA.