Debts Bombs Grow, COVID-19 Lights Fuse

The unprecedented contraction from pandemic-related shutdown policies have aggravated financial market risks that are quickly becoming reality.

The equity markets in the U.S. may have had a solid bounce over the last couple weeks, but the reprieve from red ink may be transitory. The S&P 500 is up nearly 30 percent from the lows put in on March 23 — a huge bounce — even while outside risks continue to materialize. Those risks, well-known as they are, stand to create a second wave of duress, as COVID-19 policies push the risks into reality.

One of the biggest shocks has come in the oil market. A confluence of cratering demand, due to COVID-19 shutdowns suppressing energy consumption, met with a flood of oil pumping from Saudi Arabia and Russia to create the craziest oil price swings in history. Oil futures contracts for May delivery went negative and stayed there through their expiration date, and now crude for June delivery is following its own path toward a price of zero or below.

The glut isn’t abating, either; it’s growing. As I type there are dozens of tankers filled with tens of millions of barrels of crude oil anchored off of U.S. energy ports on the Gulf Coast and California - waiting. Storage is filling up quickly, and there is a dearth of obvious places to put all of the oil. Analysts warn that big chunks of the energy industry in the United States are going to shutdown as a result of the glut, and that creates conditions ripe for a debt crisis.

Because so many U.S. oil producers are mired in unsustainable debt loads, easy money and high consumption levels were often the only things enabling them to keep pumping and refinancing their debts whenever prices dipped below production costs over the last decade. The U.S. oil industry was tested mightily in 2014 as the Saudis opened the spigots and prices collapsed, but low interest rates, high appetites for junk bonds, and the resilient U.S. economy helped it avoid crisis and emerge stronger.

Now? The economy — which, if not actually closed, has been knee-capped, in both knees — is in free fall. Demand for oil has fallen off a cliff, while supplies have continued to build, and storage is reaching capacity.

This time there is no wind at the back of the financially strapped oil producers that helped power the United States to the top energy producer in the world. As such, the debt defaults that the sector was able to avoid last time around, seem all but certain in 2020 as the economic shutdown drags on. Energy issues account for around 12 percent of the entire junk bond market; the U.S. energy industry contributes more than 5 percent to GDP; and, the inertia from a wave of defaults in this space stands to light the fuse on an even bigger corporate debt bomb.

That bomb has been growing in explosive power for nearly a decade. In the aftermath of the Great Financial Crisis, cheap interest rates and tepid growth led scores of publicly traded companies to splurge on debt and use the money to buy back shares of their own stock, thereby reducing the number of outstanding shares and artificially raising their earnings-per-share by design.

Some of America’s most recognizable companies, far from the fracking fields of Texas, have built massive corporate debt loads, and a ton of those corporate bonds are maturing in 2020. Actually, the timing of the pandemic panic could not be worse; more than $4.1 trillion of corporate bonds are maturing starting in 2020.

Analysts have warned that as much as 15-20 percent of corporate bond issuers do not have the cash flow to cover their maturing issues. Over the last several years that may not be a big deal; they merely refinanced and rolled on down the road with more debt as their fuel. But with much of the maturing bond load being the ‘junk’ rated speculative debt (think overextended fracking companies), refinancing in the current environment will be next to impossible for many of these companies.

The risk of a wave of defaults has become extraordinary, fitting for these extraordinary times. The pandemic policies, at the discretion of politicians and public opinion, have an undetermined timeline for fully restarting the economy. So the economic distortions will be protracted, and the corporate debt bomb only becomes more explosive as we move past 2020.

Actually, the largest chunk of junk bond issues are set to mature in 2022. With a deep recession inevitable, a localized debt crisis could metastasize into a falling domino with multiple knock on effects.

Corporate bond prices have been reflecting this in recent weeks as they sell off, with bond investors instead opting for the safe harbor of U.S. Treasuries. The biggest holders of corporate bonds are pensions and mutual funds, meaning that retirement account already reeling from the stock market sell off will get a double whammy as the corporate bond market crashes in tandem.

If companies are unable to refinance debts, capital markets that help companies facilitate operations with rolling credit facilities will start to lock up, as they did in late 2008 during the financial crisis. Their will be way more incentive to hold on to cash reserves than to lend them out for such purposes. In fact, we’d have a whole new credit crisis ON TOP of the pandemic panic we already face.

The Federal Reserve, with 2008 fresh on their mind, anticipated this possibility and created multiple credit facilities to address the risk during the legislative whirlwind that produced the CARES Act. To stave off the financial market turmoil, the federal government parked hundreds of billions of taxpayer dollars with the Fed, the central bank leveraged this capital into about $4 trillion and funded credit facilities to essentially replace corporate credit in the event of the system locking up.

Will it be enough? Will it actually defuse the corporate debt bomb before it explodes? Maybe; the central bank seems to have adopted a ‘whatever it takes’ mindset, following in the footsteps of the European Central Bank, yet with far more consequences.

Historically, central bank actions have been reactionary and aggravating, creating far more unintended consequences than anything else. Much like the quantitative easing after the Great Financial Crisis (QE 1, 2, 3, and 4), this gargantuan QE 5 may save some companies from ruin, while remaining unable to arrest a deflationary debt crisis. Jerome Powell will find himself pushing on a string in much the same way former Fed Chair Bernanke did, forming the basis for future asset bubbles in the process.

Even a success in defusing a corporate debt bomb could be exceedingly uncomfortable as it would cement, and justify in the eyes of many, the increasingly incestuous relationship between the U.S. Federal Reserve and U.S. Treasury. Even if it fails, and the debt bomb explodes on the scene, worsening an already unprecedented economic crisis, the only criticism seriously entertained will be that the central bank should have done more. Before you know it, the Fed has a facility to inject money into every citizen’s bank account to ‘provide liquidity’ during a rough patch.

Dominoes are lined up in multiple directions from 2020 on, but the corporate debt bomb is one that has already started succumbing to gravity. You can almost hear the whistling sound as it descends.