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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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.
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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.