Get ready to step over some landmines, investors. The number of companies defaulting on their debt is hitting levels not seen since the financial crisis, and it’s not just a problem for bondholders.
So far this year, 46 companies have defaulted on their debt, the highest level since 2009, according to S&P Ratings Services. Five companies defaulted this week, based on the latest data available from S&P Ratings Services. That includes New Jersey-based specialty chemical company Vertellus Specialties and Ohio-based iron ore producer Cliffs Natural. Of the world’s defaults this year, 37 are of companies based in the U.S.
Meanwhile, coal producer Peabody Energy (BTU) and surfwear seller Pacific Sunwear (PSUN) this week filed plans for bankruptcy protection. Shares of Peabody have dropped 97% over the past year to $2 a share and Pacific Sunwear stock is off 98% to 4 cents a share.
The implosion of oil prices is the top reason for the rise in defaults as it makes it harder for energy companies to repay debt. The Federal Reserve’s decision to hike short-term interest rates last year along with slowing global growth are also putting pressure on companies’ ability to service their debt.
Defaults are clearly an issue for bondholders, since these events mean they no longer receive payments on money lent to these companies. But the situations can be brutal for stock investors, too, as restructuring after a default can leave shares essentially worthless as the bondholders often become the new owners of the company. The rise of defaults hold several lessons for stock investors, including:
* Beware speculating on energy stocks. Brave investors have been trying to call a bottom in energy companies’ profits for several quarters now. But the sector’s pain continues as interest payments get all that more onerous given the massive drop in energy prices. Of the 46 global defaults this year, 13 are in the oil and gas sector, says Diane Vazza, head of global fixed income research at S&P Ratings Services. The surge in defaults is largely “fallout from multi-year lows in commodity prices,” she says. Energy profits keep falling. Energy sector profits are expected to drop another 107% in the first quarter of 2016 – even worse than the 55% drop in the first quarter of 2015, says S&P Global Market Intelligence.
* Cut losses. “It will come back” are famous last words for investors. When investing in individual stocks, especially some that could be even remotely flirting with default, it’s best to cut losses short. Investors in coal producer Peabody Energy defaulted on March 18, leading to the company to file for bankruptcy protection in April. Don’t think it’s just a problem for investors holding the company’s debt. Stock investors watched $1.3 billion in shareholder wealth burn up in just a year as the stock dropped from $73 a share to roughly $2 a share now. Had investors cut their losses at 10% of what they paid, they could have avoided this catastrophe.
* Mind companies on the bubble. Companies don’t usually just default without warning. Ratings agencies routinely rate companies’ credit worthiness and sound an alarm when the financials deteriorate. S&P Ratings keeps a list of the companies with the very lowest credit ratings at risk of a downgrade. The number of such “Weakest Links” jumped to 242 in March from 235 in February.