Photo credit: Flickr user addddee.

Investors aren't just selling off oil stocks these days. The junk bonds, or noninvestment-rated bonds, of energy companies are also beginning to see heavy selling as investors start to worry that drillers could one day default on these bonds. Those defaults could get so bad, according to one analyst, that up to 40% of all energy junk bonds go into default over the next few years if oil prices don't recover.

Debt: The fuel of the shale boom
It's a well-known fact that energy companies racked up a fair amount of debt to take advantage of the shale boom in recent years. Capital was flowing into the energy sector as investors eagerly provided funding to drillers. Because of this, energy companies represented the fastest growing segment of the high-yield bond market over the past few years. In fact, energy companies now account for 18% of all outstanding high-yield bonds according to J.P. Morgan, which is up from just 9% in 2009. All of this debt could pose a real problem if oil prices don't recover in the next couple of years.

J.P. Morgan's analysts estimate that if the price of oil falls below $65, and stays there for the next three years, that upwards of 40% of all of those bonds could default in a few years under a worst case scenario. That said, oil companies do have levers to pull to maintain liquidity as these companies could cut dividends and costs while selling assets to preserve liquidity. However, even under that scenario, 20%-25% of bonds could still default. The good news is that because most energy companies hedge production, liquidity shouldn't be a problem until late 2015 at the earliest. Still, investors are preparing for the worst well in advance.

Investors are reacting to future worries 
The bonds of several junk rated companies sold off this week in wake of OPEC's decision not to cut production. The bonds of LINN Energy (LINEQ), for example, were among the most actively traded earlier in the week amid fears that its heavy debt load would one day be too big of a burden. The company's B-rated notes due in 2019, for example, were trading for $0.82 on the dollar -- pushing the yield up to 11.5%. This is despite the fact that 93% of the company's cash flow in 2015 is protected and 88% is protected the following year as we see in the following slide.

Source: LINN Energy LLC Investor Presentation.

Because most of its cash flow is hedged for the next few years, there is little near-term risk that LINN Energy will default on its debt. However, that's not to say the weakening in the company's bonds won't prove to be problematic. LINN Energy could face problems down the road if it needs to access the credit markets to make an acquisition. It might be unable to borrow money at attractive terms, or worse yet, find that the credit markets are completely closed. So, while its default risk is pretty low, that doesn't mean the company might not have to make adjustments due to these developments.

Where things could become a problem more quickly is at lower rated companies as bond investors react even more swiftly in selling off these bonds. Halcon Resources (HK), for example, saw its triple-C rated bonds plunge 10% on Monday to just $0.69 on the dollar causing yields to spike to 17%. This is despite the fact that the company continues to target to hedge 80% of its production for the next 18-24 months. Bond investors are more focused on the fact that Halcon spent $324 million in capex last quarter while only generating $170 million in operating cash flow. Investors see that as an unsustainable model now that oil prices are lower and are now reacting to the company's debt profile before things ever have the chance to get worse. This could prove to be very problematic for the company as it likely won't be able to access the credit markets on acceptable terms unless oil prices move a lot higher, which means its capex spending will likely face a significant cut.  

Investor takeaway
More often than not, investors sell first and then ask questions later. Here, we see investors selling off the bonds of lower-rated companies two years before those bonds could ever become an issue. While it's quite possible that the oil markets continue to get weaker and stay weak for years, it's also just as possible that today's fears will prove to be nothing more than an irrational overreaction that's shortly forgotten a few months from now. That said, we still shouldn't forget the famous words of John Maynard Keynes: "The market can stay irrational longer than you can stay solvent."