Is High Yield Today More Resilient to Oil Volatility? Not at Any Price

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Investors, myself included, continue to marvel at the low volatility regime. Measures of equity and bond volatility remain at or near all-time lows. As I’ve discussed in previous blogs, tight spreads and benign credit conditions support a low volatility environment.

Year-to-date, high yield and other spread products continue to produce solid returns. In the case of U.S. high yield, this is a bit surprising given the drop in oil prices, down around 10% year-to-date. After all, it was only 18 months ago that a plunge in oil prices, coupled with fears over Chinese growth, sent high yield plunging and credit spreads soaring. What has changed?

US Credit Spread

As it turns out, quite a lot. There are a number of reasons why high yield markets have been more resilient to lower oil prices:

1. Global economy on solid ground

Unlike early 2016, when investors fretted over the potential of China dragging down the global economy, most recent economic indicators point to stability.

2. Better quality in energy issuers

Today, low rated companies (CCC and below) make up a smaller portion of high yield energy issuers.

3. Smaller share of the high yield market

High yield energy is now 13% of the Bloomberg Barclays High Yield Index as opposed to 17% in early 2016. That is roughly a 25% drop in its contribution to high yield spreads.

4. Improved term structures

Energy issuers are less dependent on rolling over near-term debt. And as with all high yield issuers, companies continue to benefit from still low interest rates and easy financial conditions.

5. Lower production costs

According to research from Barclays, high yield oil and gas exploration and production (E&P) companies have slashed breakevens costs by approximately 30%, to roughly $50 per barrel. This is particularly true for those E&P firms centered in the Permian Basin in West Texas, where production costs tend to be the lowest in the continental United States.

All of this suggests that high yield is not as vulnerable to lower oil prices as it was in early 2016. Work from my colleague Miguel Crivelli confirms this view. Based on his research, when West Texas Intermediate (WTI) is between $40 to $50, high yield spreads are likely to be about 45% lower than what would have been expected based on the pre-2017 relationship. Put simply, high yield energy spreads are less sensitive to changes in oil today. For every dollar increase in oil prices, high yield spread in energy only moves two-thirds as much as it would have before 2017, when oil prices were in the same range.

That said, the fact that high yield has become more resilient does not mean the sector is now agnostic to the price of oil. At some price point, a good portion of energy issuers will find themselves struggling to service their debt. A best guess: Oil at $35 per barrel could entail not only a significant widening of spreads for energy issuers but potential contagion to the rest of the asset class.

This is important. One factor that has kept markets aloft year-to-date has been well behaved credit markets. As experienced in early 2016, credit contagion could derail equities as well. The good news today is that the pain point, i.e. when high yield succumbs to lower oil, is a good deal lower than it was. This provides some cushion for both credit and equity markets.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.   ©2017 BlackRock, Inc. All rights reserved.

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This Year’s Most Disappointing Asset Class

High Yield Bonds

2015 has been a year when few asset classes performed well and many did poorly. Commodities fell by almost 30% and emerging market stocks and bonds both suffered double-digit declines. But while the travails of these asset classes are nothing new—all three also lost ground in 2014—one asset class experienced a complete reversal of fortune. High yield bonds have lost more than 5% of their value this year, their first down year since the financial crisis in 2008. That arguably makes high yield bonds this year’s most disappointing asset class.

What’s caused high yield bonds so much pain recently? High yield’s strong performance over the previous 6 years is partly to blame. The strong performance for the asset class drove down the spread—the difference between the yield on high yield bonds and the yield on treasury bonds—to less than 3.5% by the middle of 2014. That’s far below the average spread of almost 6% during the past 15 years. The small spread meant there was less cushion if some companies that issue high yield bonds started to struggle, which is what happened when the prices of energy commodities collapsed.

The Federal Reserve’s decision to start raising interest rates also played a part. The low interest rates that have persisted since the financial crisis made it easier for companies to roll over their existing debt or raise more money to keep afloat. But as interest rates begin to rise, the number of companies that are forced to default on their debt could rise as well.

In recent weeks the collapse of some high yield bond funds added further fuel to the high yield fire.  The most prominent was the Third Avenue Focused Credit Fund, which had to shut down following losses and a subsequent wave of redemption requests from its clients. This turmoil spooked investors and forced the fund to sell its holdings, both of which further pushed down high yield bond prices.

Whether high yield bonds can rebound from their disappointing year will depend on a few factors. The Fed isn’t likely to raise interest rates very far or very fast, but continued economic growth could prompt a handful of small interest rate hikes in 2016. The result would likely be a higher default rate for high yield bonds, although this could be partly tempered by the stronger economy. And if commodity prices don’t bounce back, the energy portion of the high yield market will continue to be hit especially hard.

The good news for investors is that because of high yield’s struggles in the past year, the spread over the yield on treasury bonds is up to almost 7%. The higher spread suggests that a sizable increase in defaults is already incorporated in bond prices. If the rise in defaults turns out to be less severe than expected, high yield’s 2015 performance will look like an anomaly rather than the start of a trend.

Why High Yield Still Has a Role to Play

Field

A darling asset class of this bull market has been U.S. high yield debt, as many searching for income in a low-rate world have turned to these higher-yielding bonds. According to Bloomberg data, on an annualized basis through July 31, the Barclays U.S. High Yield two percent Issuer Cap Index has gained 14.9 percent since December 2008, trailing only the S&P 500 Index (up 16.1 percent) in performance.

However, with a Federal Reserve (Fed) rate hike on the horizon for later this year and universal acceptance that it’s late in the current credit cycle, some investors are considering abandoning the asset class. The fear is that outflows from high yield could continue, putting it under pressure, and some have even speculated that high yield debt may be the next “Big Short.”

Given all this, high yield may still have a portfolio role to play for investors. Here’s why.

1. THERE’S VALUE THERE.

It’s hard to argue that high yield is cheap. Spreads (yield minus the yield of comparable U.S. Treasuries) are currently 575 basis points (bps), down from 1,930 bps in 2008, according to Bloomberg data.

But while high yield certainly isn’t cheap, the recent widening of spreads has returned some value to the asset class. Today’s high yield spread is still 135 bps above pre-2013 Taper Tantrum levels and 175 bps above the tightest post-crisis levels reached in June 2014, according to Bloomberg data. Looking forward, since the Fed has telegraphed its intent to normalize policy rates, we don’t expect another Taper Tantrum, and current spreads appear to offer fair compensation, at least on a relative basis.

2. AND ATTRACTIVE YIELDS.

Although volatility could persist, yields are attractive relative to other yield-generating instruments. Also, the current incremental pickup in yield relative to volatility looks reasonable as compared to that of fixed income alternatives.

3. FUNDAMENTALS REMAIN ATTRACTIVE.

Defaults in the high yield space still remain low, currently sitting at 1.9 percent, well below the 25-year average of 3.6 percent, according to J.P. Morgan Credit Research as of July 31.

It’s also important to remember that high yield has actually performed quite well in rising rate periods, as the chart below shows. It also tends to perform well in a positive growth environment, holding a 0.76 correlation with U.S. PMI, according to our analysis using data from Bloomberg. While we don’t expect a massive acceleration in growth, we also don’t foresee a recession. The environment we expect—slow, but positive growth—should actually be a favorable one for the asset class, maybe even relative to equities.

High Yield

To be sure, the asset class is not without its risks. Energy and mining sectors represent 20 percent of the Barclays Capital High Yield Index, according to Bloomberg data as of July 31. Yet surprisingly, oil prices can explain 70 percent of the movement in spread levels of the entire index over the last year, our analysis shows.

High yield debt issuance has also continued to reach record levels, though we expect there will not be a rush to issue once the Fed moves on rates. In addition, high yield shares certain characteristics with stocks, so investors who are already heavily exposed to equities should consider a more modest allocation. In other words, allocation to high yield needs to be viewed in the context of an entire portfolio. Finally, as we see higher levels of stock market volatility, high yield volatility is likely to rise as well.

But here’s the bottom line: While there’s no denying the above risks, high yield’s positives still argue for some allocation in portfolios, particularly for investors with aggressive income objectives.

 

This post, Why High Yield Still Has a Role to Play, first appeared on the BlackRock blog.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to BlackRock’s The Blog and you can find more of his posts here.

 

Investing involves risk, including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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The Outlook for High Yield Bonds

High yield bonds have done well since the end of the global financial crisis, providing positive returns of at least 5% every calendar year since 2009. This performance has largely been driven by an improving economic outlook combined with low (and generally declining) interest rates. As the Federal Reserve cuts back on its attempts to stimulate the economy and gets closer to raising interest rates, are the good times coming to an end for this asset class?

The answer depends on the relationship between interest rates and the performance of high yield bonds, which is more complicated than for investment grade bonds. Like investment grade bonds, high yield bonds are hurt by increases in interest rates since the fixed amount they pay to investors becomes less valuable. But higher interest rates could also be indicative of a stronger economy. Since a large portion of the return that investors get from high yield bonds is compensation for the risk that the borrowing companies could default on their debt, high yield bonds could benefit as a stronger economy reduces this risk.

High Yield Spread

The risk of default is represented by the difference between the yields on high yield bonds and the yields on treasury bonds. The problem for investors in high yield bonds is that this difference (called the “spread”) is already fairly low by historical standards. Even if the pace of economic growth substantially quickened, it’s unlikely that the spread would fall much further.

The outlook for high yield bonds therefore isn’t symmetrical. As long as the economy continues to grow and interest rates stay relatively low, high yield bonds are likely to continue to offer solid returns. But the potential upside for this asset class is limited by already low spreads, while higher interest rates or a weaker economy create downside risks.