Liquidity Risks Spike to Worst Level since Financial Crisis

Moody’s blamed oil and the collapse of commodity prices. Earlier in August, it blamed the financial turmoil around the globe and the implosion of the stock market bubble in China. Earlier, it blamed the debt crisis in Greece. Because month after month, it has been getting worse.

But it should have blamed investors and banks. They’re licking their wounds from hefty losses on these deals. More losses are on the horizon. Folks began to look at these deals more closely. And now they don’t want them anymore, not at these low yields.

So Moody’s reported today that its Liquidity Stress Index, which rises when corporate liquidity weakens, spiked to 5.1% in August, from 4.1% in July. The worst level since December 2010.

The biggest contributor? The energy LSI. It spiked to 12.7% in August, from 10.5% in July, the worst level since January 2010, at the depth of the Great Recession.

More oil-and-gas companies fell into liquidity purgatory, as Moody’s downgraded them to its lowest liquidity rating, SGL-4. Energy companies account for a little over half of the denizens of SGL-4 purgatory.

Downgrades and defaults marked August – but not all in energy. Of the 11 downgrades to SGL-4, seven were energy companies. One of them, Pioneer Energy Services, saw its liquidity rating knocked down two notches. And after seven defaults in August, the trailing-12-month speculative-grade corporate default rate rose to 2.4%, the worst in two years.

But the word is that the liquidity crisis tearing up the energy sector is not yet spilling over into other sectors. John Puchalla, a Senior VP at Moody’s:

“Excluding energy from the LSI paints a different and more benign picture of speculative-grade liquidity – showing that underlying credit conditions remain supportive and weakness in energy is not spreading broadly to other sectors.”

At least not “broadly.” And not yet. But these things always spill over eventually. That’s why Moody’s is watching it. Two week ago, he’s said that “liquidity pressures are not widespread outside of energy as steady cash flows, the slowly improving economy, and ready access to credit markets continue to provide fundamental support for US speculative-grade company liquidity.”

Junk-rated energy companies are in the grip of a liquidity death spiral. Many of them will have to be restructured, either in bankruptcy court or outside. But the non-energy junk-rated companies hope they won’t be affected, that investors will continue to buy their bonds as if nothing had happened.

So what has happened?

It’s more difficult for junk-rated companies, especially in the energy sector, to sell new bonds. Without new bonds, they can’t pay off their maturing debt, and they can’t service their bank loans and make interest payments on existing bonds. Without a constant flow of ever increasing, cheap, new credit, the fruits of the credit bubble turn toxic.

Early this year, junk bond issuance in the US still ran ahead of last year. But June was bad; only $21.2 billion in junk bonds were issued. It sent shivers down Wall Street’s spine. They blamed the Greek debt crisis. And July was terrible. China’s stock market bubble was imploding. Frazzled investors lost their appetite for risk; and only $10 billion in junk bonds were issued. August was no better at $10.2 billion, according to S&P Capital IQ’s LCD. Year-to-date, $205.8 billion of junk bonds were issued, down 1.4% from the same period last year.

It didn’t help that oil and commodity prices re-collapsed after a false-hope rally, even as the Fed stubbornly refuses to categorically and forever back away from raising rates.

Trying times for bond investors. They’ve been spoiled by a bull market that, aside from a few panics, lasted for over three decades. For companies that had to issue bonds in August no matter what, it got a lot more difficult and expensive:

Already, several of the 19 deals that priced in August had to come with healthy concessions as investors pushed back amid tough conditions. As seen in June and July, the bulk of issuance came from time-sensitive M&A and LBO issuers, to represent 39% of total volume for the month, although dividend and recapitalization/stock repurchase use of proceeds both grew as compared to previous months.

These are the spill-over effects that are still being denied. And note: junk-rated energy companies were excluded.

Energy companies borrow from banks to drill this money into the ground. These loans – usually lines of credit – are secured by oil and gas reserves. Then companies issue bonds, often unsecured, to pay off the bank loans and have some operating cash. The cycle works, until it doesn’t.

And now it doesn’t.

The value of the collateral has plunged by more than half with the price of the hydrocarbons they’re estimated to contain. Twice a year, in April and October, banks look at this collateral to determine how much they want to lend on it. So during the re-determination next month, banks are going to cut back their loans by 10% to 15% on average, according to Bloomberg, thus wiping out $15 billion in sorely needed credit.

It sets off the liquidity death spiral. Companies will have to issue new bonds or leveraged loans to pay down these credit lines. But this time, investors won’t be lining up to buy them. They’ve learned their lesson. Bloomberg:

About $7 billion of junk bonds issued by oil and gas producers in the first quarter to refinance debt have since lost 17%….

Penn Virginia, for example, one of the companies that Moody’s downgraded to SGL-4, had told investors during its July 30 earnings call that the bank would reduce the $425 million borrowing base on its credit line. Its shares became a penny stock. And the $775 million of bonds due in 2020 plummeted below 29 cents on the dollar, from 90 cents at the beginning of July. The company expects to have “sufficient liquidity” into 2016. But that’s only a few months. And it would try to raise capital as markets improve.

But raising capital will be tough. Oil markets might not improve anytime soon, given record quantities in storage in the US and internationally. And waiting for the junk bond market to improve, as the biggest credit bubble in history is beginning to deflate, is going to require a lot more patience.

Stock markets have been volatile recently, plunging and soaring sometimes the same day, and now folks that supply the juice to the startup ecosystem – VCs, pension funds, mutual funds, hedge funds even – are getting nervous. Read… “We’re Seeing the Beginning of a Liquidity Crisis” in the Startup Boom, Suddenly