Oil Price Collapse Roils U.S. High-Yield Bond Funds

Hercules In Trouble

Around mid-year many fund managers were still holding on to many of the most highly distressed junk-rated energy bonds. One favorite has been the debt of Hercules Offshore Inc, whose jack-up rigs are used for offshore drilling.

Heading into the fourth quarter, a who's who of the U.S. fund industry held the company's bonds, including Pimco, Franklin Templeton, Loomis Sayles, Avenue Capital Management, Legg Mason's Western Asset Management and BlackRock, according to Thomson Reuters data.

But since early September, prices of Hercules debt due in 2021 tumbled and yields soared to more than 26 percent from 8.5 percent, according to Thomson Reuters data. Yield spreads widened to nearly 2,400 basis points, signaling a deepening default risk.

Early last month, Hercules Chief Executive John Rynd told an investment conference how the company had more room for maneuver than in the previous down cycle and should emerge stronger from the plunge in oil prices. One reason was that Hercules' $1.2 billion in debt was unsecured, which typically means bondholders could not put a lien on the company's assets. Rynd also said the company has acted to protect its balance sheet, including laying off several hundred workers.

"That's never fun," Rynd told the Jefferies Global Energy Conference. "But you've got to protect the rest of us and somebody has to take a bullet."

However, recent fund disclosures have shown there are many more debt issues like Hercules lurking in junk bond portfolios, prompting investors to run for the exit after years of piling in. Junk bond funds saw net withdrawals of $14.2 billion this year, after $72 billion of inflows during the previous five years.

Marty Fridson, a junk bond expert at New York-based money manager Lehmann Livian Fridson Advisors, said energy-related defaults could surge above 10 percent as early as 2017 even without a recession or downturn in the U.S. economy. The current market-implied default rate for energy issues is about 4.58 percent, compared to about 2.6 percent for the entire high-yield sector.