The Boiling Point of US Junk Bonds

Investing Psychology, Stocks Mar 13, 2020 / Reading Time: 2 mins
By Edward Heng Reading Time: 2 mins

On Monday, crude oil prices had its worst daily decline since the Gulf War, with the WTI plummeting 25% on the back of a price war instigated by Russia and Saudi Arabia. Russia unexpectedly rejected OPEC’s efforts to cut oil production, while Saudi Arabia plans to boost crude output to 12.3mil barrels per day (bpd) in April in an attempt to gain market share in the oil market. On Wednesday, United Arab Emirates unofficially joined the oil price war as the Abu Dhabi National Oil Company (ADNOC) mentioned that it is positioned to boost its supply to the market to over 4 million bpd in April.

The biggest loser of this price war is the world’s largest crude oil producer, the United States. Currently, US energy companies face pressure from 2 different market dynamics.

Firstly, oil prices are facing immense selling pressure due to a slowing demand and the bid to increase supply from Saudi Arabia, Russia and recently, United Arab Emirates. With oil prices likely to persist at these levels until there is a long-term solution for the oil price war, it is increasingly difficult for US oil companies to repay their debt with the large impact on its revenue. The average break-even price of oil for US oil companies is $50-$55 per barrel, which means that most US oil companies will bleed losses when oil prices are below these levels. This normally wouldn’t be a problem for companies with a strong balance sheet to withstand near-term losses. However, US oil companies have been increasing their leverage over the years by continually refinancing their debts. These companies will have trouble covering interest and principal payments. But wouldn’t this suggest that they could just refinance their debt like they have done so in the past?

This is where pressure from the second market dynamic comes in. Investors have been moving away from junk bonds due to the rise of risk aversion from Coronavirus pandemic fears. As the drop in junk bond prices cause its yield to rise, the bond selloff raises the costs of refinancing debt once it matures, putting US oil companies with high debts at risk of default. These factors raise the likelihood of bankruptcies and job losses in the broader energy sector globally.

The realisation of this risk will likely also flow into the bond market. US energy companies are the biggest issuers of risky US junk bonds, with more than $18 bn of debt issued by the energy sector maturing in the next 3 months. 14% of the total US junk bond market comes from US energy companies. The default of these junk bonds on a large scale could disrupt the broader bond market, which is currently the most popular asset class among investors.

Blog article written by Edward Heng, Research Analyst, Maqro Capital