Synopsis: We disprove the assertion that the crude oil price and the high-yield spread decoupled in July because the credit quality of high-yield energy companies improved. Investors should expect the high-yield spread to blow out again if crude enters a sustained downturn and if greed gives way to fear among investors.
The lead topic of our recent analysis, “Oil and high-yield decouple; month-end recap” (available to LCD News subscribers), has generated a vigorous debate during the last two weeks. As we explained in that piece, there was no particular correlation between crude oil prices and the high-yield option-adjusted spread (OAS) up until mid-2014.
Once crude oil began its sharp descent, however, the BofA Merrill Lynch US High Yield Energy Index started swinging violently in conjunction with oil’s ups and downs. As the largest industry subindex, Energy strongly influenced the overall BofA Merrill Lynch US High Yield Index, which was consequently transformed into a barometer of the crude price.
It was therefore a sharp departure from recent experience when the BAML High Yield Index and, to a lesser extent, the BAML High Yield Energy Index tightened versus Treasuries in July despite a sharp decline in the crude price.
A recent Barron’s article did an excellent job of summarizing the explanations that have been advanced for July’s decoupling. The arguments can be summed up as follows:
Group A. Improvements in the quality of the high-yield energy universe
- The weakest energy credits—a quarter of all the speculative-grade energy names—have already defaulted over the past year. What remains is a less default-prone energy universe.
- Further reducing the expected high-yield energy default rate, the rating agencies have downgraded billions of dollars of formerly investment-grade energy debt to the upper end of the speculative-grade category. These issues are less likely to default than the surviving lower-tier names.
- The survivors have deleveraged through asset sales or equity offerings. As one sell-side strategist commented, “The energy companies in high-yield today are not the same companies we had two years ago. Those that remain are somewhat stronger.”
Group B. Changes in investor attitudes
- Investors do not think the July drop in crude prices will turn into a sustained decline.
- Investors who sold high-yield when oil bottomed, then sat out the rebound, do not want to repeat the experience.
Group A’s explanations for July’s decoupling, if correct, are quite bullish for high-yield bonds. They suggest that even if the attitudinal changes listed in Group B give way to more pessimistic feelings, high-yield can withstand a new downturn in crude prices, thanks to reduced risk that cheaper oil will trigger defaults.
We reject this optimistic interpretation.
It is true that to a not inconsequential extent, fallen angels have displaced original issue high-yield bonds within the high-yield energy universe. Nevertheless, the ratings mix within energy is worse than it was two years ago, implying increased, rather than decreased, default risk.
Moreover, there has been no material improvement in the energy sector’s credit quality since Feb. 11, 2016, when renewed slippage in the crude price drove the OAS on the BAML High Yield index to an astronomical 1,984 bps, up from an interim low of 994 bps on Nov. 4, 2015.
If the high-yield energy universe’s credit quality did not materially improve after February, then the BAML High Yield Energy Index should have widened dramatically versus Treasuries when the crude price fell in July, unless the spread-widening was in truth explained by the attitudinal factors listed in Group B.
Carrying the logic one step further, if credit quality improvement did not explain the July decoupling, then investors should expect both the energy and the overall high-yield spreads to blow out once again if:
- crude drops on a sustained basis and
- investors become less worried about selling at the bottom and more worried about failing to sell before the bottom is reached.
Quantifying the energy sector’s alleged quality improvement
As detailed in the chart below, fallen angels currently represent a larger portion (25.3%) of the BAML High Yield Energy Index’s face value than in mid-2014. At that date, just before the crude price began to plummet, fallen angels accounted for just 5.5% of the face amount. The proportion has even risen significantly since the Feb. 11, 2016, wide point in the high-yield spread, when 14% of the face amount of the high-yield universe consisted of fallen angels.
The past two years’ ongoing shift toward fallen angels, however, does not correspond directly to the trend in default risk. In the table below, we stratify the BAML High Yield Energy Index by rating, in percentage-of-issuers terms, on the same three dates depicted in the preceding breakdown between fallen angels and original issue high-yield bonds.
As the bulls maintain, today’s high-yield energy universe is not the universe of two years ago. They are exactly wrong, however, about the direction of the change in credit quality.
Credit quality is lower by this important measure than it was in mid-2014. The CCC-C component, the source of most defaults that occur within one year of the measurement date, is twice as large as it was on Jun. 30, 2014 (40.00% versus 20.00%). Downgrades from BB or B have more than offset any credit quality improvement resulting from addition of comparatively high-quality fallen angels. The BB component has shrunk from 28.82% to 23.87% of energy issuers.
True, the CCC-C component has declined since Feb. 11, 2016, but only from 40.99% to 40.00%. No one, we trust, will seriously argue that the BAML High Yield Energy Index’s OAS tightened (from 831 to 823 bps) in July 2016, instead of widening by almost 1,000 bps, as it did between Nov. 14, 2015, and Feb. 11, 2016, because the CCC-C component declined by not quite one percentage point in the interim.
Another way of expressing the change in riskiness of the speculative-grade energy universe over the past two years is to calculate average expected one-year default rates for each measurement date, based on the ratings mixes shown in the preceding graphs.
To generate these numbers, we use average annual default rates per rating category for the period 1970–2015, as reported by Moody’s. The chart below shows that in an average year, the June 30, 2014 energy universe would have been expected to suffer a 3.09% default rate. That rate jumped to 5.89% on Feb. 11, 2016, a material change to be sure.
Since then, however, the expected one-year default rate has declined only negligibly, to 5.82% (this analysis is less than 100% precise due to data constraints). It beggars belief, however, that the energy sector’s dramatic change in response to declining oil prices between February and July of this year resulted from as minor a reduction in credit risk as that which occurred in the last month.
Incidentally, let us dispose of the knee-jerk reaction of some high-yield promoters who say that ratings are wrong and irrelevant.
We do not contend that every single rating of S&P Global Ratings, Moody’s, and Fitch Ratings exactly captures its expected default probability, down to the second decimal point. In aggregate, though, the ratings do a pretty good job, as evidenced by Moody’s data for the years 1970–2015 showing that over every interval from 1–20 years, the Caa-C cumulative default rate exceeded the B rate, which in turn exceeded the Ba rate.
Furthermore, the market—which rating agency bashers claim is smarter than the raters—by and large agrees with the ratings. The chart below shows that even at the more granular, alphanumeric level, today’s median option-adjusted spreads within the energy sector increase in a nearly monotonic fashion with each step down the rating scale.
Bottom line: Improvement in credit quality does not explain why, in a radical departure from its behavior of the preceding two years, the high-yield energy sector tightened in July in the face of a sharp drop in the crude oil price.
A more credible explanation
Judging by the evidence presented above, the conclusion seems inescapable that July’s decoupling reflected attitudinal changes of the kind listed above in Group B. Investors must be aware that reversals in such attitudes are routine occurrences in the securities markets.
Yes, investors do not currently expect oil prices to fall on a sustained basis, but that was undoubtedly true for many market participants when the crude price initially ticked lower in the second half of 2014. Yes, selling out at the bottom in crude prices and missing the rebound is currently a bigger worry for high-yield investors than riding the market to an even lower level, but lurches from greed to fear are proverbial in financial markets.
In light of these realities, investors should be mindful of the following excerpt from the Barron’s article cited above:
“Still, don’t expect this disconnect between high-yield paper and oil to last if the price of crude keeps falling. ‘Long-term, high-yield has to reflect at least in part the fundamentals, and if fundamentals are that the price of oil is going to be lower for longer, high-yield has to eventually reflect that,’ warns Sean Coleman, chief credit officer at Franklin Square Capital Partners.”
Even one buy-side bull, who puts faith in the high-yield energy credit quality improvement that has resulted from cost-cutting by U.S. oil shale producers, acknowledges the limitations of that cushion. David Riley of BlueBay Asset Management says that persistence of the July decoupling depends on investors continuing to see the recent crude price drop as a mere technical move, rather than a reflection of global oil demand fundamentals. “Investors should carefully watch for any recoupling of oil prices and global financial markets,” he warns, “as the oil price moves below $40 a barrel.”
In a similar vein, sell-sider Brad Rogoff of Barclays Capital cautions that the energy sector “looks a little rich” and that a drop below $40 probably entails “some downside.” We regard those comments as understatements.
Keep in mind that even though the BAML High Yield Energy Index’s OAS contracted in July, the sector lost ground to the Non-Energy component during July. Between June 30 and July 31, Energy tightened by just eight basis points, versus 60 bps for Non-Energy, meaning that Energy widened by 52 bps versus the rest of the high-yield universe.
In short, investors did not truly ignore the crude price’s decline, blithely assuming that all of the weak energy credits had already defaulted. Rather, in their desperate quest for income, investors drove other high-yield bonds up so spectacularly that relative-value considerations prevented energy issues from managing to show an absolute decline.
There is no shortage of evidence or opinion to support our view that a push to an ever more overvalued state for corporate debt, rather than improvement in the energy sector’s credit risk, explains the July decoupling. According to J.P. Morgan Chase & Co., investor demand for bond funds is the highest since at least 2007 relative to demand for stock funds. Valuation has naturally suffered. “I’d really question if you are being rewarded for the risk you are taking,” comments Duncan Sankey, head of credit research for Cheyne Capital, regarding the corporate market. For further insight into the risk-reward tradeoff, see the following section of this piece, which updates the FridsonVision Fair Value Model.
Another bottom line: The real reason for July’s decoupling between the crude oil price and high-yield spreads is investors’ desperate search for yield. If that pressure abates, there will be no solid basis for arguing that Energy—and by extension the high-yield asset class as a whole—cannot fall in response to a future drop in oil prices.
Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors LLC, is a contributing analyst to S&P Global Market Intelligence. His weekly leveraged finance commentary appears exclusively on LCD, an offering of S&P Global Market Intelligence. Marty can be reached at [email protected].
Research assistance by Michael Li and Yanzhe Yang.
Follow LCD News on Twitter.
This story first appeared on www.lcdcomps.com, an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.