Junk-Debt Time Bomb: Ticking Till The Fed’s Money Dries Up

Wolf Richter www.testosteronepit.com  www.amazon.com/author/wolfrichter

On Sunday, New York-based discount retailer Loehmann’s with 39 stores did what certain other retailers – and a large number of other junk-rated companies – will do once the Fed allows a sense of reality into the markets: it ran out of money and filed for Chapter 11 bankruptcy protection.

Third time’s the charm. It had filed for bankruptcy twice before: in 1999 and in 2011. Maybe this time, it will stick. After fruitlessly trying to sell the business as a going concern – 39 companies looked at its books and averted their eyes in disgust – Loehmann’s board opted for “a wind-down and liquidation process.” Now it will try to auction off the assets, Reutersreported. Loehmann’s Chairman Michael Appel offered two reasons for the failure: “increased competition in the off-price retail channel” and “limited access to capital.”

The stores would remain open but were an “enormous cash drain,” and it was “critical” that asset sales begin by January 7, the company said. In short, competitors had clobbered the company; and seeing how it was losing sales and bleeding cash, investors didn’t want to sacrifice any more money.

But in these crazy times of ours, Loehmann’s was the exception.

“Struggling retailers may have never had it so good,” the Wall Street Journal explained. But dark clouds are building up just beyond the sun-drenched horizon: the Fed’s money-printing and zero-interest-rate policies have made yield investors desperate, equity investors reckless, and lenders careless, as the Fed has succeeded in expunging the very concept of risk.

Borrowers whose sales are declining (OK, that’s about half of corporate America), whose operations are bleeding cash, and whose balance sheets are buckling under their load of debt have no problem getting their hands on new money to burn through at dizzying rates.

Bubble finance in the years leading up to the financial crisis caused a building boom – which goosed GDP and employment and made everyone look good – not just in housing, hotels, and other areas, but also in retail. After the whole construct collapsed, too many stores were left to compete for strung-out consumers.

And strung out they are: While the unemployment rate has come down nicely into a politically correct ballpark, the Employment-Population Ratio – workers as percent of total working-age population – stubbornly clings to lows last seen in the early 1980s. It peaked at 64.7% in April 2000. Last month, it stood at a miserable 58.6%. It says: yes, companies have been hiring, but only enough to keep up with the growth of the working-age population.

For many individuals, the situation has gotten worse: Median household income, adjusted for inflation, fell 8.3% between 2007 and 2012, the Census Bureau reported. The top 5% are back at their real income peak, with the top 20% getting closer. But incomes of the remaining 80% are drifting ever lower (graph by quintile). An insidious twist for a recovery – and for retailers that cater to the increasingly hollowed-out middle class.

So luxury retailers have done well. But….

“The middle-tier types of firms are suffering,” explained Jack Kleinhenz, chief economist for the National Retail Federation. “There is a lot of competition in retail, and they have very thin margins. There’s going to be a sorting among retailers.”

The market share of Sears – including K-Mart – has dropped to 2% in 2013 from 2.9% in 2005. Sales have declined for years. The company lost money in fiscal 2012 and 2013. Unless a miracle happens, and they don’t happen very often in retail, it will lose a ton in fiscal 2014, ending in January: for the first three quarters, it’s $1 billion in the hole.

Despite that glorious track record, and no discernible turnaround, the junk-rated company has had no trouble hoodwinking lenders into handing it a $1 billion loan that matures in 2018, to pay off an older loan that would have matured two years earlier. Extend and pretend.

Teetering RadioShack obtained $835 million in financing last week. The new money would replace a smaller loan arrangement. Suppliers and landlords can now be confident that RadioShack has enough cash to pay them over the near term. If that confidence evaporates, suppliers are going to balk sending more merchandise and landlords are going to bite their fingernails. Which would be a step closer to bankruptcy.

Then there’s J.C. Penney. Sales plunged 27% over the last three years. It lost over $1.6 billion over the last four quarters. It installed a revolving door for CEOs. It desperately needed to raise capital; it was bleeding cash, and its suppliers and landlords had already bitten their fingernails to the quick. So the latest new CEO, namely its former old CEO Myron Ullman, set out to extract more money from the system, borrowing $1.75 billion and raising $785 million in a stock sale at the end of September that became infamous the day he pulled it off [read.... J.C. Penney And Goldman: Lies, Scams, And Rip-Offs].

With no credible plan in sight to slow the bleeding, with only a snowball’s chance in hell of a real recovery in a tough retail environment, and mired deeply in junk territory despite the equity offering, JCP had simply delayed the inevitable by milking desperate, yield-starved lenders and blind equity investors. JCP now bandies about improved sales figures for the last two months. It has done that before. But it still hasn’t stopped burning through investor money.

These and other junk-rated borrowers across corporate America have had no trouble wringing more money out of investors. Endless new money meets endless commitment to kick the can down the road. Nothing can possibly go wrong.

The default rate by junk-rated companies is proof. It has been declining. In October, it was 2.5%; a year earlier, it was 3.6%, according to Moody’s Investors Service. Defaults only happen when money dries up for a company. But with the Fed’s money spigot wide open and short-term interest rates near zero, desperate yield-starved lenders, crazed bond investors, and reckless stock jockeys are all chasing after every opportunity to leverage the free funds from the Fed.

Companies can simply go on losing money and burning cash and shouldering more debt, while digging an ever-deeper hole. For Wall Street, which creams off fees, it’s a great deal. And it works wonderfully – until it doesn’t. See Loehmann’s.

Meanwhile, risks – the very concept that has been expunged – are coagulating into a fermenting ugly mass. One of them is interest-rate refinancing risk. These junk-rated companies have to refinance their debt over the next few years while also having to raise new money to cover their cash bleed. If the Fed ever sinks low enough to start allowing interest rates to drift up, that coagulated mass of junk debt will have to be refinanced at much higher rates – if it can be refinanced at all. It’s a time bomb. It’s ticking. And it will blow up, with big pieces of shrapnel flying every which way.

Municipal bond investors, a conservative bunch eager to avoid rollercoasters and cliffhangers, are getting frazzled. Bankruptcies and the Fed’s taper cacophony are a toxic mix. And losses are mounting. Read…. Fear and Trembling In Muni Land