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The End of the Road for Junk Bonds

August 24, 2012

The last 4 decades, except for minor hiccups, has been a dream run for junk bonds.  Even after the credit crisis, thanks to central bank QE programs, companies that should have been put out of their misery survived thanks to yield chasing junk bond investors.  And banks, hiding bad loans through evergreening (reminiscent of Japan), also contributed their mite to zombie companies surviving.

Our definition of junk bonds is not the same as that of a typical fixed income investor.  A fixed income investor would classify bonds rated below BBB- by one of the rating agencies as junk.  We would classify bonds issued by the following class of companies as junk:

  • Companies which produce goods whose use is of a discretionary nature (not aimed at the high-end of the market), and whose products would be the first to be cut by consumers feeling the effect of austerity programs of governments (either those programs have started, say as in Europe or programs that will soon start-say in the US, Brazil, Russia and India).  In addition, these companies would be leveraged a 20% fall in EBITDA would bring to question debt servicing ability.
  • Leveraged companies that are executing big capital expenditure programmes now.  Most of these projects will simply not generate the returns forecast when they were on the drawing board a few years back.  In addition, if the project execution skills of the company are questionable, a barely viable project would cross over to the other side
  • Companies that relied on government subsidies (such as renewable energy companies in some countries, ship builders in others, semi-conductor fabs in still others etc) will see their businesses crumble.  There simply is not enough cash to go around when governments deleverage.
  • Companies that are owned by private equity players.  Many funds raised in 2007 and before will be looking for an exit.  On the way out, they will inflict pain on creditors.  Thanks to covenant-lite loans of the bygone era, creditors will be able to do very little to defend themselves.

An added cause for impending doom is the sharp increase in global supply of junk bonds, as zombie companies try to stay afloat through refinancing of existing debt and financing of operational losses.  The issuance of junk bonds jumped 88% in July compared to the previous month.

Not so bright fund managers (or perhaps, to be charitable to them, crooked fund managers out to make a quick bonus) point to the record cash on corporate balance to argue all is well.  Firstly, not all the cash is real (see https://crediteye.wordpress.com/2011/08/02/general-electric-the-notion-of-cash-on-corporate-balance-sheets/ ).  And when the cash is real (say at Apple, Qualcomm etc), it is not on the balance sheets of zombie companies.       The last time we checked, cash on Apple’s balance sheet cannot bail out chip company AMD, that is surviving one day at a time.

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From → Credit Analysis

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