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UBS Exposes The "Scary Reality" Of High Yield Energy
To be sure, we’ve written plenty on the rough road ahead for HY energy.
The darkening outlook for the sector not only reflects a decisively bearish forecast for crude (see Morgan Stanley’s "far worse than 1986" call), but also the fact that time appears to be running out on the various lifelines that have kept heavily indebted producers afloat over the course of the crude downturn.
For instance, the hedges which accounted for some 15% of Q1 revenues for nearly half of North American O&G companies are set to roll off which, along with persistently low commodity prices, should weigh heavily on banks’ reassessments of credit lines due in October. Meanwhile, investors’ appetite for HY issuance and equity offerings may soon wane as even the retail crowd gets wise to the fact that this is one dip that most assuredly should not be bought.
For an in depth review of the above, see the following:
- Energy Companies Face "Come-To-Jesus" Point As Bankruptcies Loom
- Shale "Revolver Raids" To Resume In October When "Rubber Meets The Road" For HY Energy
- "Far Worse Than 1986": The Oil Downturn Has No Parallel In Recorded History, Morgan Stanley Says
- E&P Writedowns Loom As Reserves Overvalued By 60%
- Shale Drillers About To Be "Zero Hedged" As Loss Protection Expires
Here with more on the coming carnage and why HY investors may be profoundly unaware of just what’s in store, is UBS.
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From UBS
High yield: The scary reality
The current sell-off in US high yield bond market appears controlled based on the consistent but moderate declines in daily cash bond index prices, but underneath the hood several participants are characterizing the price action as carnage. At an index level the average HY bond has fallen about 2 points week-over-week, but index data is notoriously stale and lagging; there are numerous examples of issues down 5, 7 or 10 points on light volumes despite no direct exposure to commodity prices and no material firm specific news. In our view, recent market behavior has exposed several hidden fragilities in the market ecosystem.
First, too many investors were overweight heading into the sell-off, in particular in the energy complex. The plunge in oil and commodity prices following the Iran deal and Chinese demand fears has intensified the potential fundamental stress in resource related sectors, and this outcome was not anticipated by the consensus. Anecdotally we've heard several credit funds have raised cash balances, but there are two problems with this thesis: one, the rise is arguably structural as outflow risks rise in an environment of tighter monetary policy, rising credit risks and lackluster performance. Two, many of those who raised cash we believe added beta to continue producing above-benchmark returns and limit tracking error. This strategy fails in a decompression scenario where low quality and illiquid credit underperforms.
Second, the sensitivity of energy firms to oil prices is not linear anymore- at depressed levels what would be considered 'normal' levels of commodity price volatility can have outsized effects on fundamentals and market prices. Simply put, the risk symmetry in stressed sectors is to the downside for bondholders. The rub is central bank quantitative easing drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, loan and emerging market debt to satisfy yield bogeys. The problem, however, is some of the tourists underappreciate the exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle turns annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range (versus $83 currently) - especially given expected recoveries average in the $20 - $25 context1. The scary reality is those investors in triple Cs are seeking high single digit returns when they are likely to end up with negative total returns over the next several years (if our view of the credit cycle proves correct).
Third, the perceived illiquidity in the marketplace at present is due not only to seasonal and month-end effects as well as regulation; the phenomenon also has its roots in uncertainty bred on information gaps and asymmetry. It is well known that the overall HY market has doubled in size; sectors that witnessed more buoyant issuance in recent years like energy and metals mining have seen debt outstanding triple or quadruple. And the number of new names and issues has grown a commensurate amount. The reality is that resources in many segments of the market have not kept up.
Chart: Bloomberg
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Of course when the retail crowd finally does head for the exits en masse, fund managers will be forced to come face to face with illiquid secondary corporate credit markets where a lack of market depth means transacting in size has the potential to spark a fire sale. As for what comes next, we'll close with what we said on Sunday in "The Junk Bond Heatmap Has Not Been This Red In A Long Time":
At some point, investors will tire of throwing good money after bad hoping to time the bottom tick in oil just right, at which point the commodity capitulation which we noted previously will spread away from just commodities and junk bonds, and spread to all sectors and products, including stocks. We can only hope this does not coincide with the Fed's increasingly more amusing desire to hike rates imminently.
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Can't get much higher yield energy than Fukushima.
October credit reassessments....? My hunch is it would be a bad idea for the banksters to wait til tomorrow for credit line reassessments.
They will put it off as long as they because their bonus comes first.....
I heard talk of rather large payments from bond issuers not showing up at work today but only by amount not by issuer.
They WILL monetize oil. Just like subprime, student loans, cars etc etc.
Gold and silver, in physical form, WILL protect you from imploding currencies. Water and food security comes first though.
Mike Milken's legacy of junk bonds; quintessential financial weapon of Reaganomics age.
"We can only hope this does not coincide with the Fed's increasingly more amusing desire to hike rates imminently."
Fuckin unbelievable, the mispricing of risk and misallocation of capital as a result of ZIRP may cause carnage in certain high yield bond environments that can only be averted by further mispricing of risk and misallocation of capital via the continuation of ZIRP all on the backs of the elderly and savers and hopefully to pass on this misallocation of capital onto those who are not already owners of real estate or have yet to be fully vested in the stock market, so as to allow hedge funds to offload their risk and erroneous capital allocation decisions.
I'm starting to get the hang of this.....
Exactly. ZIRP is evil. It punishes savers. A group that made America. Why punish them more to save the bubbles? If ZIRP is good medicine why is the financial world so sick?
It's more likely that the chumps had no idea where their 401k money was going when high yield was promised
I'm sure UBS can teach us a thing or two about high yield junk. Just ask the customers who bought their PR bond funds, now largely worthless.
It is all coming to pass. Having herded the seniors and others living on yields into increasingly risky areas, now the plug will be pulled on them once again and this time they will be flushed. I have had a ringside seat.
Still, my brokers, advisers lenders etc.. have done OK