Higher Default Rates Expected For US Coal Sector

Fitch_Ratings

Should Arch Coal, Inc. (Arch) and Peabody Energy Corp. (Peabody) file for bankruptcy, the industry bond default rate would surpass 50%, according to Fitch Ratings.

The wave of bankruptcies in the U.S. coal space has caused the broader metals/mining (M&M) sector default rate to rise to double digits for high yield bond and leveraged loan indices.

A spate of coal defaults has resulted from unsustainably high debt leverage from past acquisitions amid an environment of weak coal pricing. The low pricing and defaults were driven by over-supply of steam coal and metallurgical coal, burdensome regulations, and competition from low priced natural gas for electric generation business. Three major producers, Patriot Coal Corp., Alpha Natural Resources Inc., and Walter Energy Inc. as well as some smaller mining bond issuers including: Xinergy Corp. and Winsway Enterprises Holdings Ltd. defaulted earlier this year.

Both Arch and Peabody have a reasonable likelihood of default with an Arch default more likely. If both large coal producers file for bankruptcy, Fitch’s coal industry trailing 12-month (TTM) bond default rate (based on dollar volume) jumps to 55% from 28% while propelling the broader M&M sector TTM rate to 21% from 10%, narrowly edging the prior high set in 2002. The TTM M&M leveraged loan default rate would also climb to 25% from 11% should these two defaults materialize.

A potential coal bond default rate of 55% is enormous; however, the sector is an extremely small component of the overall U.S. high yield market — the overall high yield market default rate is 2.9% for TTM September 2015. Coal accounts for just $15 billion in a $1.43 trillion high yield bond universe (M&M comprises 4% of the market, or $61 billion). Similarly, M&M loans comprise a relatively small $20 billion (2%) of the $900 billion U.S. leveraged term loan market.

The large volume of M&M sector defaults, persistence of challenging coal markets, and lack of strategic buyers for coal properties will weigh on reorganization enterprise valuations or asset sales prices in the bankruptcy cases. Fitch believes low values combined with overleveraged pre-petition balance sheets will result in low or zero recovery rates for holders of unsecured M&M debt in the reorganizations. The poor recovery expectations are consistent with the low trading prices on distressed loans and bonds in the sector. As of Wednesday, Arch’s par weighted senior unsecured facilities (those involved in the distressed debt exchange) were bid at 7 while Peabody’s par weighted bond facilities were bid at 27.

Arch Coal initially extended an offer for an unsecured for secured debt exchange on July 2, 2015, which Fitch would deem a selective default and classify distressed exchange if it eventually proceeds. If the distressed debt exchange occurs based on the most recent amount tendered, rather than default triggered by a bankruptcy where all issues would be counted in the default volume, the M&M rate would increase to approximately 12%. The company’s secured lenders are trying to prevent the exchange and the transaction remains in limbo. Without an exchange, a bankruptcy filing or default triggered by a missed interest payment is likely before year end in Fitch’s view.

Peabody Energy’s outlook is marginally less dire given its lack of near term maturities and sufficient liquidity to sustain operations for the time being, but there is substantial credit risk. Fitch forecasts leverage to exceed 9x through 2016 and downgraded the issuer to ‘CCC’ in July 2015 to reflect our view that liquidity could become constrained in the absence of higher metallurgical coal prices.

[Fitch Ratings]

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