Warning: There May Be No Cash for Junkers

Nelson D. Schwartz writes at The New York Times that a significant problem may arise for junk bonds due to mature in the three-year span from 2012-2014. Most of these must be rolled over into new issues or else the issuers will face bankruptcy.

There are about $700 billion in junk bonds coming due between now and the end of 2014, distributed as shown in the following graph:

In 2014 there will be more than 16 times as much junk to be rolled over or retired compared to this year. This is complicated by the fact that there will be $30 - $60 billion in CRE (commercial real estate) loans maturing in each of the five years over 2010-2014.

These speculative grade securities will be competing with trillions of dollars in demand by the US Treasury, shown in the following graphic:

The difficulty will be compounded if interest rates rise over the next five years and if credit spreads widen, which is likely in a rising interest rate environment with heightened default risks.

Schwartz provides considerable background for this situation:

As was the case with the collapse of the subprime mortgage market three years ago, derivatives played a big role in the explosion of risky corporate debt. In this case the culprit was a financial instrument called a collateralized loan obligation, which helped issuers repackage corporate loans much as subprime mortgages were sliced, diced and then resold to other investors. This made many more risky loans available.

“The question is, ‘Should these deals have ever been financed in the first place?’ ” asked Anders J. Maxwell, a corporate restructuring specialist at Peter J. Solomon Company in New York.

The period from 2012 to 2014 represents payback time for a Who’s Who of private equity firms and the now highly leveraged companies they helped buy in the pre-crisis boom years.

The biggest include the hospital owner HCA, which was taken private in 2006 by a group led by Bain Capital and Kohlberg Kravis & Roberts for $33 billion, and has $13.3 billion in debt payments coming due between 2012 and 2014. Another buyout led by Kohlberg Kravis, for the giant Texas utility TXU, has $20.9 billion that needs to be refinanced in the same period.

Long term investment in lower grades of corporate debt has heightened risks under a variety of economic scenarios. However, some of the risks will not arise if:

Interest rates remain relatively low;

The economy grows robustly over this time interval (2010-14);

Government debt funding requirements come in below expectations; and

Solvency issues at major banks are resolved sufficiently that they can increase participation in the corporate and commercial lending markets.

The above scenario is what we all hope for. However, I'm not basing a lot of my bets on this rosy outlook. And whatever bets I do consider, I will place them all securely, with hedges in place.

Disclosure: No positions