Storied weapons maker Colt Defense LLC is in a pickle. But it’s not the only junk-rated company in a pickle. The money is drying up. Selling even more new debt to service and pay off old debt is suddenly harder and more expensive to pull off, and holders of the old debt – your conservative-sounding bond fund, for example – are starting to grapple with the sordid meaning of “junk”: Colt announced on Wednesday that it might not be able to make its bond payment in May.
Colt’s revenues plunged 25% to $150 million for the three quarters this year. It’s spilling liberal amounts of red ink. It has $246.5 million in assets, including $61.5 million in Goodwill and intangible assets. Without them, Colt’s $185 million in assets are weighed down by $416.8 million in liabilities, leaving it a negative “tangible” net worth of -$231.8 million. Cash was down to $4 million. In its 10-Q released on Wednesday, Colt admitted that there was “substantial doubt about the Company’s ability to continue as a going concern.”
Moody’s rates the company a merciful Caa2, reflecting “its very high leverage and weak liquidity position,” with negative outlook. This babe is deep into junk territory – and headed for default.
As is to be expected after this much financial engineering, the company is largely owned by a private equity firm: Sciens Management holds “beneficial ownership” of 87% of Colt’s LLC interests.
Last week, it got some reprieve, if you can call it that: Morgan Stanley agreed to provide a $70 million senior term loan. This new money replaces Colt’s existing $42.1 million loan that the company said it would have otherwise defaulted on by the end of December. That’s how that original lender got bailed out: new debt to pay off old debt.
The new loan will also permit Colt to make a $10.9 million interest payment. Otherwise, the company would have been in default by December 15. That’s how those bondholders got bailed out (for the moment): more new debt to service old debt.
The loan would leave Colt with an additional $4.1 million in cash: new debt to pay for new losses.
It also disclosed that “notwithstanding the additional cash the Company obtained from the MS Term Loan, risk exists with respect to the Company achieving its internally forecasted results and projected cash flows for the remainder of 2014 and 2015.” And if a number of miracles fail to occur, “it is probable that the Company may not have sufficient cash and cash equivalents on-hand along with availability under its Credit Agreement, as amended, to be able to meet its obligations as they come due over the next 12 months….”
So management has a plan to deal with its “increased liquidity challenges”: in addition to a number of operational goals, it would be “seeking ways to restructure the Company’s unsecured debt.” Owners of that unsecured debt are going to squeal. And if that doesn’t work, well….
This scenario is starting to play out company by company, hitting the most fragile ones first, as investors are becoming at least somewhat reluctant to throw good money after bad. That reluctance has to be overcome with additional compensation in form of yield, thus a greater expense for the companies when they can least afford it.
The junk-debt-funded oil and gas shale revolution is particularly on the hot seat. Its ever-faster moving fracking treadmill of steep decline rates and costly drilling is now smacking into the plunging price of oil [read… How Low Can the Price of Oil Plunge?].
Hoping that the price of oil and gas would only go up, energy companies have drilled $1.5 trillion into the ground since 2000, and they’re now shouldering a huge pile of debt – much of it junk rated. This year, energy companies have issued 15.2% of all new junk bonds. Yet, oil and gas production is only a small part of the US economy. In 2013, their junk bond issuance made up 10.3% of all junk bonds. Back in 2004, it made up 4.3%. That’s how the fracking party has been funded.
The more the price of crude drops, the deeper these companies sink into the morass. At some point, defaults will begin to cascade through the system. The total return on the Merrill Lynch High Yield Energy Index for the last three month was a loss of 5.8%, the worst performance since the fourth quarter of crisis year 2008.
More broadly, the average yield of CCC or lower rated bonds, the riskiest junk out there, shot up from 8% in early July to over 10% on Tuesday, according to the BofA Merrill Lynch US High Yield Index. And the High Yield Total Return Index for these types of bonds lost 5.3% over the same period.
Meanwhile the BofA Merrill Lynch US High Yield BB Index, which groups together less risky junk bonds, has barely budged with yield at a historically low 4.8%. It’s still fully suspended in the middle of a magnificent bubble.
This is just the beginning. Yield-desperate investors, driven to near insanity by the Fed’s zero-interest-rate policy, were holding their noses and closing their eyes, and picked up the riskiest junk just to get a tiny bit of extra yield, and that demand drove down yields to ludicrous levels.
But reality – as Colt bondholders are finding out – cannot be pushed out forever. Now investors decide to take a whiff and glance at the junk they’re picking up, and they suddenly see some of the risks that have been obvious all along, and they’re either walking away or clamoring for more compensation. That’s what is happening at the riskiest end so far.
Junk debt can swoon with stunning speed. The market becomes illiquid as buyers evaporate before your very eyes. If a financial institution faces redemptions and has to sell in that environment, its fund would take terrible losses on those bonds.
During the financial crisis, when the new money dried up for highly leveraged companies, yield on CCC-rated bonds soared above 40%, and the value of the bonds collapsed. The Fed sacrificed savers and retirees to bail out these bondholders with a flood of liquidity and interest-rate repression, no questions asked. With the arrival of ever cheaper money, defaults were pushed into the future.
During the taper tantrum last summer, the yield of the Merrill Lynch High Yield CCC Index jumped from 10% to 16% in no time, only to get another Fed-inspired reprieve. But now, even the Fed frets about the bubble in that space, about excess risk taking, and investors blindly “reaching for yield.” It’s worried about banks and large institutional investors getting caught with their pants down again, and how that could – given the enormous amounts – jeopardize “financial stability,” which has become the Fed’s mantra. So the Fed has been hammering on them, and it has sent its regulators into the fray to put an end to the frenzy, and another instant rescue when the bloodletting starts in serious is now doubtful.
But when should investors panic? Ha, there’s some new thinking about the markets in this crummy global economy where nearly all assets are overvalued. Read… It’s Official: Party Now, Apocalypse Later