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Oil Market Tremors Rattle High-Yield Bonds

A bearish oil market is leading investors and advisory firms to rethink their below-investment-grade fixed-income strategy.

As leveraged producers feel the impact of declining global oil prices, high-yield bond returns have been on the rise. In 2014 the Bank of America Merrill Lynch U.S. high-yield option-adjusted spread index rose by more than half its level on June 23 to reach more than 5 percent on the last trading day of 2014. The index tracks the difference between the yield on non-investment-grade bonds and those of U.S. Treasuries. Leading this trend is the energy sector. In a report issued December 16, 2014, Sean Darby, chief global equity strategist at Jefferies Group in Hong Kong, noted, “The disproportionate capital raising in the energy complex versus other economic sectors over the last few years ensured that a fall in oil prices would impact overall market liquidity more than any other factor.”

Indeed, some analysts estimate energy company issuers’ total share of the non-investment-grade U.S. debt market at more than 15 percent. Generally, cheap oil has been a boon for the overall U.S. economy, with lower gasoline costs meaning greater consumer spending power. In the thinly traded high-yield credit markets, however, the negative impact has been profound. Investors are now left to consider the working capital and interest coverage ratios of energy sector companies that were quick to raise capital in a low-interest-rate environment. Despite the higher risk associated with bonds that trade below investment grade, many investors, starved for yield, have been looking to the so-called junk market in recent years to provide a more meaningful return than that available in high-grade debt categories. Many investors are now rethinking that strategy, however.

“We have seen a lot of movement in the energy sector of the high-yield market, and possible knock-on effects on the broader market are a legitimate concern,” says Bryan Mullin, director of capital markets research, alternative investments, at Slocum, a Minneapolis-based institutional investment consulting firm. “Most operators have a pretty good operating buffer, however, and it could take 12 to 14 months before we see these concerns ripple through the system.” Mullin notes that recent announcements of budget cuts at borrowers such as Houston-headquartered exploration and production company Marathon Oil Corp. are a positive sign. Marathon announced in mid-December that it will reduce expenditures by 20 percent in 2015, amounting to almost $1 billion, as new oil assets become less profitable as prices fall. Mullin notes that junk bonds issued by energy companies may be entering a long cycle of depressed prices and cautions that values are not yet compelling. “Don’t expect that you can jump in over the near term,” he says.

Yet there are some valuations that are attractive in this bear market for oil, according to Sean Chaitman, president and chief investment officer for Shelter Rock Management, a financial advisory firm based in Jericho, New York, that invests in high-yield bonds. “In the case of lower oil prices and large capital expenditure cutbacks, it comes down to balance-sheet strength and the per-barrel price at which different energy companies can make money,” he says. In the months leading up to the oil sell-off, Shelter Rock’s fixed-income strategy was underweight on energy sector bonds. Chaitman cautions that investors still need to be selective when buying into this segment

The impact of rising yields for energy producers on high-yield markets has also spilled over into exchange-traded funds and closed-end funds. “ETFs create a simple wrapper for investors to modify easily their exposure to high-yield fixed-income markets,” says Andy McOrmond, managing director at WallachBeth Capital, a New York–based institutional brokerage that focuses on ETF and portfolio trading. Mohit Bajaj, director of ETF trading solutions, also at WallachBeth, notes that despite the volatility injected into the market for high-yield exchange-traded products during the recent oil sell-off, short interest has remained relatively stable and borrows have been easily obtainable. Bajaj attributes this stability to a maturing institutional appreciation of exchange-traded products.

One thing that remains unclear for junk bond investors is whether the current slump in oil prices will continue for a significant period of time or prove to be just a blip on the radar. The oil supply glut anticipates a clear bearish market, whereas the futures curve for West Texas Intermediate crude oil suggests a more mixed trajectory.

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