Tuesday, April 3, 2012

Slim Pickings

Junk Bond Market Is Looking Pretty Picked Over

Every day I do essentially the same screen on the bond market.  I search for all junk rated bonds that are at least B3/B- rated across all maturities (junk rarely goes out more than 10 years) with a lot size of 10 bonds ($10,000 face amount).  I then sort the search results by yield to maturity, highest to lowest.  I am then presented with a list of the highest yielding bonds I can buy online through Schwab and can scroll down through the offerings until the yields drop below my minimum requirement (10%).  When I see a name I have not seen before, I usually do some preliminary due diligence and if the bond looks promising I will do more digging and possibly purchase some of the bonds.  Most things I look at do not meet my credit quality standards, but in most market environments I end up buying a bond here and a bond there.  However, lately the pickings have been extremely thin to non-existant.  It is becoming clear that the junk bond market is becoming less attractive and may be approaching the point where prudent investors do not buy bonds.

As I detailed here http://lifeinvestmentseverything.blogspot.com/2012/01/dumpster-diving-in-junk-bond-market.html there are clear times when investors should buy with both hands and times when investors should simply stay away from the junk bond market.  The (somewhat arbitrary) cut-off level is a spread over Treasury bonds of about 5%.  However, there are other signs that the junk market is getting in to dangerous territory.  Among them is new high yield bond issuance, which reached a record level in the first three months of 2012 (see http://www.businessweek.com/news/2012-04-02/high-yield-bond-sales-to-match-300-billion-high-jpmorgan-says).  These are all ominous signs for anyone actively buying junk in the present market.  The only remaining signs of a junk market to run away from is the emergence of progressively weaker covenant packages (possibly including "covenant light" bonds), excessive amounts of leverage being offered to weak companies, and exotic structures such as "pay-in-kind" bonds.  We are not there yet and the market may shy away from such excesses, but investors sould be on the look-out.

In the meantime, I continue to search for opportunities.  Most of what is offered seems to be the "walking wounded" issues and those in certain industries.  Notably, a number of bonds offered (and with prices falling steadily) are issued by coal miners, particularly Applachian coal miners like Patriot Coal (ticker PCX).  The coal industry is under pressure because the largest consumers of coal (utilities) are finding ultra-low natural gas prices very enticing as an alternative.  As a result, thermal coal (the kind you burn to generate power) prices have dropped and utilities may be setting themselves up to permanently reduce their coal usage via the building of natural gas-fired generating plants instead of coal-fired plants.  To some extent, demand from China, India and other emerging nations has soaked up excess coal supplies.  However, the reduction in demand has been sufficient to reduce prices for some time.

Coal mines have high fixed costs, especially underground mines (open pit mines as are common in the Powder River Basin are less costly to operate).  Appalachian mines are largely underground mines and the reduction in coal prices has suddenly rendered formerly profitable mines uneconomic to continue operating.  So Patriot and its competitors have been shutting down mines, laying off workers, and bleeding cash.  Unfortunately for these companies, the capital they raised and spent on the now unprofitable mines is gone and they are suddenly looking overleveraged.  What the industry needs is an increase in coal prices.  How could this happen?  The most obvious catalyst would be a spike in natural gas prices.  Natural gas prices will eventually rise, but it is not clear at all how long it might take for that to happen.  If it takes too long, the Appalachian coal miners could well have transited bankruptcy by then.  If mines are close enough to transportation infrastructure, a pick-up in growth in China could also increase coal prices and save the Appalachian miners.  In the meantime, these companies continue to burn cash and the price of their bonds keeps falling.  With no clear bottom, I don't find the bonds attractive even with low to mid teens yields offered.

As always, do your own due diligence, consult your advisor and be careful.  You can lose money on this stuff.

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