US high yield (HY) spreads have widened significantly over the past few days, to levels last seen in early 2016, with likely further spread widening to come. The selloff is a result of simultaneous negative shocks to demand and supply.
The spread of the novel coronavirus (Covid-19) has increased the downside risks to the fundamental picture for the US HY market. While much uncertainty remains, a prolonged period of economic disruption could impact a broad cross-section of issuers in the asset class and drive up the default rate, albeit from historically low levels.
Compounding the situation is the plunge in oil prices in the wake of the collapse of talks between members of OPEC+1 and the subsequent price war between Russia and Saudi Arabia. If current oil prices persist, a majority of the issuers within the HY exploration and production (E&P) and energy services industries could be at risk of default over the longer term.
To put things in perspective, energy is the largest sector in the US HY market, constituting approximately 11.5% of the BAML High Yield index.2 Bonds of certain HY energy companies, especially those in E&P and energy services, are trading down significantly on the back of the 33% decline in West Texas Intermediate (WTI) crude oil prices since Thursday 5 March.
Looking ahead, the outlook for the HY sector will be largely dependent on the duration of both the coronavirus outbreak and the oil price war. Outside of energy, most HY issuers are starting from a position of strength with respect to their balance sheets, given the high amount of refinancing activity and focus on deleveraging in recent years, and so they should be able to weather a quarter or two of depressed operating results and limited capital markets access. We believe the steep decline in oil prices and interest rates should provide further support to many non-energy HY issuers.
With regard to energy, a surge in defaults seems likely, and we will also be watching for a potential wave of fallen angels3 from the energy sector in the investment grade sector, which we estimate could total a few tens of billions of dollars—still manageable compared to the US$1.2 trillion size of the overall HY market.
We will be watching potential fallen angels more broadly given the possibility of a more sustained hit to economic prospects globally, but at this point we would still not regard this as a significant risk to the overall HY market.
- WTI crude oil is down to US$31 per barrel, off ~25% on March 9 after a 10% decline on Friday, 6 March.
- The price decline on Friday was driven by news OPEC+ was unable to reach an agreement to cut oil production by 1.5mm barrels per day (bbls/d), on top of the current 2.1mm bbls/d production cut that is set to expire at the end of this month.
- OPEC had agreed to cut production by 1.0mm bbls/d contingent upon non-OPEC producers cutting 0.5mm bbls/d.
- Russia (the largest non-OPEC producer), however, refused to cut production.
- News that Saudi Arabia slashed official selling prices (“OSPs”) by US$6 to US$8 per bbl, arguably signaling an all-out oil price war with Russia, spurred a second wave of selling pressure on oil prices over the weekend and into early trading during the week of 9 March.
- We believe Russia grew weary of cutting production and ceding oil market share to the United States and viewed the current environment as an opportunistic time to try to wound an already struggling US shale oil industry. We also believe the Kremlin has geopolitical motivations, including retaliation for US sanctions impacting parts of the Russian energy industry.
- Saudi Arabia appears to be retaliating against Russia’s refusal to go along with production cuts. It is not clear at this point whether this will ultimately be a tactic to bring Russia back to the negotiating table or whether Saudi Arabia is prepared to bear a lower oil price for an extended period with the aim of ultimately regaining market share and benefitting in the intermediate term.
While we anticipate our HY portfolios will be negatively impacted by these events and some issuers could default, we believe the ramifications are manageable from an overall portfolio standpoint and relative to benchmark indices.
We’ve actively managed our exposure to the more vulnerable E&P and energy services industries, which are the most commodity-sensitive, and have favoured midstream/pipeline names, which we believe are likely to be relatively more resilient. Furthermore, some of our energy holdings have investment-grade ratings, and we believe these bonds should be relatively more defensive.
Outside of energy, we have relatively limited exposure to sectors such as retail and transportation that are more at risk of a direct impact from the coronavirus fallout, and we recently further reduced exposure to gaming.
We are focused on mis-pricings in individual credits and looking for opportunities both in issuers that may have gotten disproportionately oversold as well as ones where downside risk may not be adequately reflected in market prices yet.
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1. OPEC+ is an alliance of oil producers, including members and non-members of the Organization of the Petroleum Exporting Countries.
2. Source: Bloomberg. BAML High Yield Index, as of 6 March 2020. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
3. A fallen angel is a bond that was initially given an investment grade rating but has since been downgraded to high yield status.