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Bubble Trouble for Junk Bonds?

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For investors looking for better yields following the 2008 financial crisis, the junk market has become popular. Leading to near zero interest rates was the quantitative easing era that in turn hurt returns on bonds. Ever since the economy has rebounded, significant resources have been poured into junk bonds, recently growing to an impressive $1.3 trillion.

During the easing era, the biggest debt issuers were producers of energy that since 2010 raised $550 billion. Now with shale oil production in the United States rising, growing concerns of a supply surplus have led to the price of crude oil plummeting. The benchmark for US crude oil prices slumped roughly 42% since hitting its peak in June.

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From January through October of this year, $50 billion in junk bonds have been issued by energy companies, which make up nearly 14$ of the US high-yield bond market. However, there is fear among investors that some energy producers in the US may not meet obligations of debt. Many investors believe these shale oil companies will have an extremely difficult time servicing old debt, while at the same time making an investment in operations that is substantial.

In April, one natural gas producer, Rice Energy, Inc. (NYSE: RICE), raised $900 million, more than the $250 million originally sought. These bonds were grabbed up by investors at the time while ignoring information that losses over three years had been reported by the company.

Since this past June, bonds relating to energy have dropped over 13% while in the meantime junk bonds this year have declined more than 5.5%. Profits for major producers felt the squeeze as oil prices dipped below $60 per barrel. In addition, there were a number of smaller energy companies that were completely pushed out.

The declining oil prices had serious repercussions on the capacity for these companies to borrow. Since hitting a peak in September, Energy Infrastructure Portfolio and Goldman Sachs North American Shale saw net asset value drop over 24%.

When yields have skyrocketed and demand remained relatively inactive, there is reluctance among energy companies to issue more debt. In looking at junk bonds and comparable US Treasuries, the spread in June has widened to 5.28% points from 3.23% points. As reaction has soured, some companies to include C&J Energy Services, Inc. (NYSE: CJES) have chosen to postpone the issuance of debt.

Once again, investors are eager to minimize losses from junk bonds from energy companies by turning to the insurance segment. In the last two months there has been a spike on the Markit CDS North American High Yield Index, climbing 20.2 to 375.9 basis points. In comparison the high-yield debt ETF for BlackRock’s iShares iBoxx High-Yield Corporate Bond ETF (NYSEARCA: HYG) has dropped over 3.5% also in the past two months.

Because a ripple effect on stimulus produced a bubble within the market for energy junk bonds, it is anticipated that there will be serious repercussions in the market as this time around the supply of junk bonds is much greater. There are indications that more low-quality bonds are being issued.

Currently, a price war between shale producers in North America and OPEN gains momentum, some experts believe that shale companies with operations in the Marcellus region will soon face bankruptcy. Historically, this region is known for being the most expensive in which to operate. Therefore, a domino effect in the US junk bond market could take place, followed by spreading sometime in the future to similar sectors.

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Don Miller

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