Corporate Distress Spreads; Energy Junk Is a Haven

in financial conditions that's happening as we speak. We'll be getting his insight a bit later on in the show, but before we do. Eliza Ronaldshannon, with Bloomberg News, you've been all over the biggest distressed debt stories for as long as I can remember. How is the global banking crisis affecting the troubled companies that you cover well so far? It's it's interesting. It's a bit of a double edged sword.

On one hand, these companies have already been creeping into further tightness in terms of their ability to obtain new financing. The rise in rates has been increasing the amount of distress that that's out there really reducing their options in terms of financing themselves. So that has meant a lot of turning to you know, private debt funding, these specialized firms that will lend to them at quite high rates, which creates only a snowball effect of further burden on

the companies. But the interesting side of this is that it's possible, you know, given that the backdrop is already tough and one of you know, the outlook being a lot of more distressed now that things have reached a real crescendo in one regard, a lot of a lot of market participants are hopeful that this will slow down the fed's rate hikes, in which case the struggling and the and the overindebted companies will benefit. So can I ask you about the funding cust I mean, they have

increased across the board. But but if you're going to the private market, how much more are you're gonna have to pay? You're gonna have to pay? I mean, it's interesting because you're it's it's more about it's it's it's like you're gonna have to pay more. But it's more than the option being nothing at all. So I mean it'll be at three percentage points more in terms of

the yield on a loan um. We're looking at some of the loans that we see recently in for instance, bankruptcy financing, which is only one step beyond um distressed financing. Some of these loans are going for fifteen percent um. I think there was one company that recently took out a small loan at twenty percent to avoid bankruptcy. So that becomes a really onerous It doesn't sound sustainable to me.

I mean, these companies just running themselves like they're giving themselves short term lifelines, but they're not long term sustainable, are they right. It's a lot of short term lifelines. It's a lot of the companies hoping and praying that they will have a experience an operational turnaround in the meantime.

So sometimes these will be pretty short term loans and they're thinking, our whole business model is going to be different and amazing in two years, so if we can only get through this tough time will be smooth sailing. And of course sometimes that is true. Sometimes they need to take on you know, you have to kind of dig yourself out of the hole and that means throwing good money after bad but it can work out in the end. It's hard to know in the moment which

outcome you're going to have. But of course for executives that are in the positions, better to buy some time and not have to be the one who sank the ship. Yeah, absolutely right, So you talked about the double edged sword. Rates are going up, but that you know also at the same time, because the banking crisis, the FED may

have to take its foot off the accelerator. But that's not good for these companies, right, If the economy is getting worse, right, that's net worse for them for you know, more distress, Right, it is, it's net worse for them, certainly. I mean, the the hope is that it will at least tame inflation. So the the real entrenched fear is for a stagflation a sustains stagflation situation where inflation is

high and even a recession doesn't um tame it. So to some extent, you know, people are hopeful, I mean, the markets are, especially for high yield debt or always suspiciously hopeful about everything. But um, you know, it's it's a little bit of a this might hasten the cycle and at least let us come back out of it a little faster, but it's not good for corporate growth and it's not good for the company's actual operational outlook.

There any particular sectors that are in trouble companies specifically, it's really not a sector specific at this point. The companies, it's just going to be the companies that have had to or had to or have just taken on a lot of debt in order to finance themselves, you know, in sunnier times when rates were really low. So that's going to be a lot of private equity owned companies

that were acquired through leveraged buyouts. It also can be companies like Carvana, which is not private equity owned, but it took on almost five billion dollars worth of debt during the pandemic in order to fuel its massive growth goals. And now it was one of those companies that didn't have a lot of revenue or it wasn't profitable at the time, And of course that's you know, not unheard of for a company to really focus on growth over profits.

But the worst case scenario is for that that era to lead into an environment where there's no turning back and you have really put a lot of burden on the company, and the economy is not in a place where it will become profitable. So it just sounds like a really depressing outic I'm to see on the credit guy, so I'm always looking on the dark side. But in terms of like the the actual trade, somebody is making

money here right now. Everyone is unhappy. So who's who's who's rolling in the in the big bus on someone else's paying here. Well, one place you're seeing funds try to make money, and it's a little bit too soon to know who's really going to cash out on some of these bets because they involve products that you know

don't immediately turn over. But um, there's a lot of activity relatively speaking, in the market for credit default swaps, and that is a product that allows investors to bet against companies, and so that became a snowball issue during

the financial crisis. But there's a lot more regulation involved now and the markets are smaller, But that is one place where hedge funds and particularly macro funds can kind of pile onto the negative sentiment and they can bet against companies where the market psychology seems to already be that everyone is in fear and there's a little bit of panic going on, and then once those bets are noticed and recorded, it exacerbates things often. So that's one

place where there will be profits taken. You talked to one of the biggest guys that you know. He makes his money at moments like this, Bill as Weinstein. He always catches in at this point. He smells blood in the water. What's what's his view now on the bank bonds? Well,

he is he saw the displacement in the market. He thought that the um and thinks still that there's a little bit too much selling and that there's been some forced selling on the part of counterparties, you know, other banks that need to just effectively manage their risk and just our buying protection in a way to hedge their exposure and just stay within some reasonable limits in terms

of their the risk that's on their books. Um So, the demand surging when and when a bunch of banks have to do that at the same time, gives sellers of CDs, which could be any any fund or that that decides to write up a contract they can really sell them at over Arguably inflated prices, and so then you're getting you know, you're you're selling a product that is higher than its market value might be. It does he think the route is over? Does he think that

the unions has further to full or is it? Is it stabilizing that well, it's it's tough to know because the market is so a liquid that it changes every day. Um what's more interesting in the horizon for people like Weinstein and UM funds pursuing these kind of bets is that the same phenomenon of hedging exposure and that creating a lot of demand for CDs is now expanding into other industries. So first it was just banks. Now you're seeing it in the insurance companies. UH, their CDs is

being traded very heavily. There's a lot of demand for it, and that's because insurance companies themselves have a lot of exposure to bank debt. They have that debt on their own balance sheets where they manage their assets. And that was because it was supposed to be quite safe debt, and so that's that's what they to invest in so that they have a decent return without a lot of risk. But now that it's suddenly become risky, people are betting

against those insurance companies. Very interesting. So before we talk to Spencer Cutter at Bloomberg Intelligence about the energy setor what's the next big story to watch here, Eliza, I think it might be how the interest in CDs and how the rush to hedge or bet against the credit of various companies expands even beyond insurance. So does this trickle down to a lot of trading activity in other

CDs indexes or in single name CDs. Thank you, Eliza Ronolds Hanon for Bloomberg News, Thanks so much for joining us. Thanks we look forward to reading all your scoops on the Bloomberg terminal and of course at Bloomberg dot com. So, as I said earlier, we're very fortunate to have Spencer Cutter here from Bloomberg Intelligence. Thank you very much for joining us. Spencer, thanks for having me. The companies that you look at, um, you know, I just remember a

whole well of paying there as well. I mean, we've been talking for years about the problems in the energy sector. They borrow a way too much money and they can't pay it back. How are they affected by what's going on in the banking set to what's what's you know, roiling them in terms of like the global termoil was

seeing they are they all falling apart as well? Uh No, actually quite to the contrary, and I think some of the troubles that we've talked about over the past several years have helped put the energy sector into a much stronger position today, which could leave them in a really, relatively speaking to other sectors, a good position if we do see a sort of another financial dislocation or banking crisis.

We had two waves of bankruptcies in the last five or six years, the first one in twenty sixteen when oil prices fell below thirty dollars a barrel, and then again in twenty twenty when oil basually went to zero briefly, and as a product as a result of that, you had a lot of the weaker companies wiped out take you know, go to bankruptcy, wipe out a bunch of debt, and either go away or re emerge with very little

debt on their balance sheets. And the ones that survived, you know, they had a couple of near death experiences and they got religion, and they started using free cash flow and asset sale proceeds to pay down debt. So the overall health of the high yield energy sector, and I primarily cover high yield, but this applies to investment grade as well. I believe you know, the overall health of the sector from a credit standpoint is probably the

strongest it's been in decades. So you'll see if you're trying to tell me that the high yield junk junk energy issues are a safe haven in all of this mess, well, if you if you want to go back to two thousand and eight, and not that we are going to have a repeat of two thousand and eight, but that's obviously sort of the benchmark that a lot of people

go by. Oil prices plunged from about one hundred and forty five dollars a barrel down to around thirty four, and as a result, credit spreads in the energy sector did jump by quite a bit. That said, the sector then was the spreads were still three hundred, three hundred and fifty basis points tighter than the overall market despite

that sort of dislocation. And one thing to point out is in two thousand and eight, the midstream sector was actually not part of the Bloomberg high yield Energy Index, and I'm looking at the index overall index spreads here, and the midstream sector is moved in and I think it was twenty fourteen out of utilities, and that's by far the safest sector within energy, and so that would account if we have another repeat today, I would think

that would help keep overall energy spreads down. But if you look at leverage ratios today and free cash flow expectations today, even after we've seen natural gas prices fall to two dollars per thousand cubic feet from north and nine dollars just in August, you know, the overall the top ten high yield independent energy debt issuers, they're expected to have an average leverage ratio this year at the end of this year of less than one and a half times, and all but one of them is expected

to still generate positive free cash flow. So not to say there won't be some dislocation, not to say the high yeld energy sector won't suffer somewhat. And I do think if if we do have another you know, big recession or another financial lending crisis similar to or in the spectrum of two thousand and eight, yeah, sure, it's gonna it's gonna impact energy, but I do feel like the sector's well positioned. And also keep in mind where we're coming from and how energy relates to the rest

of the world today. When you do have a lending crisis, a credit crisis, and banks are pulling back, concreditors are pulling back, they really start to look for companies that have hard assets, that have a long track record of generating cash flow that can be monetized. And that's energy. You've got that in spades in this sector. So people they stay you know, hey, you know, get me out of this latest fintech crypto vaporware company and let me buy some good old fashioned oil and gas stocks. But

two things. One thing, you know, you mentioned the drop in gas oils drop from one hundred and twenty to seventy. Surely that's going to hurt. Yeah, it hurts. And so the free cash flow expectations have come down, but for

most of these companies are still positive. What's happening is these companies are not are not ramping up production to sort of grab the you know, one hundred dollars plus barrel of oil opportunity to either saying I'm I'm going to focus on free cash flow and I'm gonna just spend as much as I need to spend to maintain production.

So yes, the falling oil prices will hurt UM, but there's still in a really good position where like I said, we entered the year this year, I think in the strongest position from a credit standpoint in certainly in my memory, in many decades. But the other thing, the other thing I wanted to raise with the ESP crowd. I mean, you're destroying the planet with your fossil fuels. Come on, you know, Yeah, there there's a dichotomy there. There's a tuget,

a push and pull. Um. ESG is certainly something that you're hearing a lot about, not only from the broader community, but every company I follow talks about it, and they're investing heavily in carbon capture and other ESG related ventures. You know, pipeline companies may benefit from this quite a bit because you had a huge build out of oil

and natural gas and refined product pipelines. As sale the shale boom started, you started seeing more generation production come out of West whether it's West Texas or the Marcellus up in New England, or the northeast and the backing that's been largely built out, and you've seen the backlog of projects for the midstream companies come down dramatically, But now some of them are starting to come back up because all these producers are saying, well, I'm going to

capture carbon and use it and inject the CO two into my well to help stimulate production, and I need a CO two pipeline for that, So they're building CO two carbon capture pipelines. So, just to drill down into one name in particular, Occidental Petroleum, Warren Buffett is buying shares in that company. What does that mean for bondholder is that's one of the biggest borrowers in our universe

in terms of US credit markets. Yeah, Occidental is sort of the poster child for high yield own gas companies. They used to be investment grade and they levered up to buy Anadarko that didn't turn out too well. They lost their investment grade ratings and oil dropped to zero,

and everybody thought they might go bankrupt. They've since paid off about twenty billion dollars a debt and are on the verge of moving back into the Bloomberg high you'ld or sorry the Bloomberg Investment Grade Index, and Berkshire Warren Buffett obviously is playing a big role there. He lent them a lot of money for the Anadarko acquisition, and he started buying a dish shares and keeps on buying

and buying and buying. From a credit standpoint, at some point you've got to start thinking, does Oxidental become strategically important for Berkshire Hathaway and therefore get some sort of implicit credit support. You know, as Berkshire, do they own enough stock to have they invested enough in this business that if oil prices dropped back down to thirty dollars a barrel for an extended period, Well, Berkshire, which has billions and billions of cash, say we're not going to

let this go under. We're going to stand behind them, We're going to lend them some money, or we're going to inject some capital into this company to help get them through this tough point. It's really hard to say where that line is crossed. Um. They believe Berkshire owns about twenty four percent of Occidental today, They have warrants to buy a lot more, and I think they have approval to get up to like fifty percent. So you know, fifty percent certainly seems like a line in the sand,

but it may it's a fuzzy area. But that's something to consider, is when do you think that this becomes a strategically important investment for Berkshire and that they are going to back it up and help support Occidental if they should run into any sort of credit or financial trouble. So overall credit energy sector, the big year for this particular pasit of credit is a moment for energy bonds. Uh well, energy bonds have they certainly did very well

the last year, year and a half. And the problem run into is there is sort of a floor in terms of credit spreads, and I think we hit that floor last year. So not to say that spreads half to widen. And you've certainly seen credit spreads hold in even though oil and natural gas prices have fallen. I mean you see credit spreads for natural gas producers like Chesapeake Energy and Southwestern they're about the same place today, even though natural gas is two dollars per thousand cubic feet.

Those credit spreads are still the same place today as they were back when natural gas was by fifty, so people are not hitting the panic button yet. That said, if oil goes back to one hundred and natural gas goes back to six seven seven dollars, it's hard to see that there's a lot of upside just because the upside, you know, the windfall from those higher prices, is being

steered towards shareholders. All the companies have spent the last several years using they're free cash flow to pay down debt, and now they said, okay, we're kind of done with that, and maybe we'll pay down a little bit more, but we're really going to start using any free cash flow we generate to pay dividends or buy backstock. So for from a credit standpoint, there's not a whole lot more

upside left, but not much downside either. Well, you know, there's always some downside in the credit world, and that's all we think about as credit analysts. But relative to a lot of the other industries out there, I feel pretty good like that the high old energy sector is pretty well positioned. If we should hit another financial storm

in the near future, so and unlikely safe haven. Who'd have thought we'd be running for cover in junk energy bonds but Spencer Cutter from Bloomberg Intelligence, thank you so much for joining us. Thank you and do read all of Spencer's analysis on the Bloomberg Terminal and I look forward to catching up again very soon. Thanks again also to Eliza ronalds Hannon from Bloomberg News. Read all of her scoops on the Terminal and at Bloomberg dot Com.

Definitely important to keep an eye on the distressed debt story right now, no matter what part of the market you're in, and Eliza and her team will continue to break a lot of news in that market over the coming months and weeks. I'm James Bromby. It's been a pleasure having you. See you next week on Credit Edge.