by Wolf Richter, Wolf Street:
“Weakest link” companies worst since October 2009.
The “weakest links,” according to S&P Global Ratings, are financially squeezed companies that S&P rates B- (neck-deep into junk), with “negative” rating outlooks or negative implications on CreditWatch. They’re uncanny predictors of corporate defaults. When the number of “weakest links” rises, the default rate will soon rise as well. The last three times it rose enough, a recession kicked in. The last two times were accompanied by fabulous fireworks in the markets.
In August, the number of “weakest link” companies rose to 251, the highest since October 2009, up from 140 two years ago, and heading toward the record of 300 in April 2009 when the financial world was coming unglued.
These weakest links have $359 billion in debt outstanding.
They serve as “potential default indicators” because they’re almost 10 times more likely to default than run-of-the-mill junk-rated companies, according the S&P report, cited by Bloomberg. Blame oil and gas? The markets surely would like to. But only 62, or 25% of the weakest links, are oil and gas companies. The next largest sector: 34 financial institutions for a share of 14%.
Among the eight companies that were inducted to the elect group in August: Chesapeake Energy, Hornbeck Offshore Services, satellite operator Intelsat which is already holding a gun to bondholders’ heads to get them to undergo a bond exchange with haircut, which S&P called “a distressed restructuring and tantamount to default.”
And it includes Tesla, which is burning cash faster than anyone can keep up with, and which has been raising even more cash via a torrent of follow-on stock offerings and debt sales, all to maintain enough liquidity. More on that in a moment.
The S&P US default rate rose to 4.8% as of July. S&P expects it to rise to 5.6% in June 2017. That may be optimistic. The default rate was 1.4% in July 2014. As it began rising over the past two years, S&P consistently underestimated how far it would go. Last November it was 2.8%. In nine months, it has jumped 2 full percentage points.
The default rate for energy companies is 21.7%.
And yet, liquidity is once again sloshing knee-deep through the system, trying to find a place to go. This includes refugees from negative interest rates in Europe and Japan. In this environment, even teetering Chesapeake was able to swap debt for equity and raise new money to be burned in the near future.
It’s hard to default when you keep getting new money to service old debts. Junk-rated issuers, now a hot property for NIRP refugees, have been able to refinance their debts and raise money to cover operating losses.
In that vein, back to “weakest link” Tesla. S&P rates it B-. The next step down is CCC. On August 1, S&P warned that it might downgrade it further, following its $2.6 billion acquisition of another money-losing, cash-burning Elon Musk company, over-indebted SolarCity. S&P slapped a CreditWatch “negative” on Tesla, based on “significant risks related to the sustainability of the company’s capital structure following the proposed transaction.”
Together, Tesla and SolarCity had over $5 billion in long-term debt at the end of March, and the deal would cause a “meaningful increase in the combined entity’s debt leverage.”
With its lofty stock price – though it’s down 27% from its 52-week high – and its insane market capitalization, Tesla has the ability to raise money in the equity markets without breaking a sweat, as it has repeatedly done, including the $2 billion follow-on offering announced in May. For now, investors are more than willing to pay an arm and a leg for a company that, after 10 years of existence, has not yet figured out how to stop losing money, and that sells so few cars that its sales are not even a rounding error in the 74.4 million new vehicles to be sold globally this year.
As long as Tesla, Chesapeake, and other “weak links,” plus a host of companies that are not yet “weak links,” have access to the equity market for more money, they’re unlikely to plunge over the default cliff. Creditors know this. As long as the stock price is high enough, they’re willing to lend more money. So these companies even have access to the credit markets. And everything is hunky-dory.
“Markets are now relatively sanguine about default risk,” John Lonski, Chief Economist at Moody’s Capital Markets Research, wrote in his latest missive. Moody’s US default rate is already 5.5%, just about at S&P’s expectation for June 2017 (5.6%). If the default rate continues to rise and if markets become less “sanguine” about it – if they start once again to fret about defaults and losing their shirts – they can trigger a chain reaction that feeds on itself. It happens every time.
Investors will suddenly seek higher compensation for the risk of default by demanding higher interest rates, and yield spreads begin to widen. Thus borrowing money becomes more difficult and for some companies impossible. They’re facing a liquidity crisis.
Equity investors see this too, and being at the bottom of the capital totem pole, they’re worried about losing everything in a default and debt restructuring. So they’re massively bailing out, and shares crash.
Now creditors, including banks, see that the company cannot raise new money in the equity markets, and they’re tightening the noose, trying to protect what they can.
“Thus, a worsened default outlook diminishes liquidity by increasing the cost of both debt and equity capital,” Lonski writes. When liquidity dries up for a company that is burning cash like a wildfire, it’s soon over.
If enough companies go through this, there are consequences: after each of the last three “episodes” when Moody’s default rate reached 6.5%, it “continued its ascent,” Lonski writes:
After first reaching 6.5% in February 2009, April 2000, and February 1990, the default rate eventually crested at 14.7% in November 2009, 11.1% in January 2002, and 12.4% in June 1991. Coincidentally, a recession overlapped each of the default rate’s last three peaks.
In addition, the equity market suffered deep setbacks at some point during the 12 months prior to the peaking of the default rate.
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