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Be Careful if you Bond Leverage with Junk Bonds – the oil and gas case study

It is not fresh news that the oil and gas industry is in a slump due to a secular shift in oil prices. Firings and non-renewal is common.

The recent interesting development was Marco Polo Marine refusing to take delivery of a SembCorp Marine oil rig stating that there are defects. There is a stream of announcement from the 2 companies with SembCorp intend to earn the money and deliver without defects on time.

On the investment front, if you take a look at the Singapore corporate bond market, there are much juicy bonds yielding 10%.

I can envision some rich patrons of private banking being influenced to buy these bonds, and perhaps some would even buy it on leverage.

Bond Leveraging is similar to you paying a 20% down payment on a private property that you intend to rent out, and borrowing the other 80% at less than 2% interest.

If the net rental yield is 3%, your leverage private property returns become 9%.

Private banking likes to sell their clients bonds as well, and the attractive part is that unlike the 3-6% interest you can get on margin, private banking can give you less than 2%.

So if you borrow 50% and the bond yield is 10%, then your leverage return becomes 18.5%.

That looks tremendously attractive.

Where can we get 10% yielding bonds? To attractive investors you have to give them a good return for the risk they are taking up. For the bonds to be priced to yield 10% and above to maturity, there must be quite a fair bit of risk.

What are the risk?

Corporate defaults for one, where the company are not able to pay the interest and the principal.

The junk bonds for many oil and gas companies were issued at 7-8% yield but due to the increase risk they have fallen to 10% and above.

While the yield looked appealing, they also indicate that risk that your principal will be permanently impaired may be high.

In Singapore Oil borrowers seek more slack  to avoid bond defects, we start seeing some of the top oil and gas bond borrowers are pleading leniency to loan covenants.

Dyna-Mac Holdings Ltd., part-owned by Keppel Corp., this month are asking bond holders to alter certain debt limits or profit targets as contract delays wreck firms’ earnings.

Pacific Radiance Ltd. is also seeking to tweak a rule on its 2018 bonds that requires interest coverage above three times, compared with 4.1 times as of Sept. 30. The company’s debt to equity ratio, a key measure of leverage, jumped to 98.4 percent at the end of June from 75.7 percent at the end of December.

Ezra Holdings Ltd., which successfully raised S$200 million from a rights offering in July, is asking noteholders to change certain requirements on its bonds after it agreed a $1.25 billion subsea services joint venture with Chiyoda Corp.

If you have bought into the bonds thinking high returns, compensate for high risk, then your model of value may be wrong.

In investing, we buy at value when all the risks have become known or those unknown risks have surfaced, those time is during credit crisis when previous risk that is masked from investors are unmasked.

Value is better assessed now that many of these oil and gas bonds are under scrutiny for default. True bargain value hunting are ugly, where you wouldn’t want to touch this sector.

In the case of these oil and gas bonds, the question is which company have strong enough business, or strong enough parents to weather this storm.

Looks so much like what the shipping trust were facing when the charter rates plunged (refer to my FSL Trust Business report)

If you want to d?o bond leveraging, at least do it with rated bonds. The yield on the bonds may not be as high, but you are leveraging them, and are subject to the risk of the bonds being called back (for some)  and interest rate risk.

Do you know of friends who have done similar ? How are they doing in these bond leveraging deals?

 

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Pierre

Friday 27th of November 2015

The issue is moot though because many banks will give little to no gearing for High-Yield bonds (anything below BBB-), and also have other restrictions (based on maturity or if the bond is subordinated). High leverage then usually means AAA or AA bonds with medium to short maturity, which means very low yield.

Kyith

Saturday 28th of November 2015

hey Pierre, thanks for sharing. However, it would be interesting to know why private banking were allowed this, or they also curate well for their clients

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