This week's chart depicts the bifurcation in spreads and performance between energy- and non-energy-related bonds in the JPM HY Index. Given the poor liquidity in the high-yield market, when the largest sector in the index takes a nosedive, there is a risk it can drag the broader market with it.
Two examples of this from previous non-recessionary periods are the telecom and technology sectors in the late 1990s and the auto sector in 2005, the latter ultimately being benign and the former causing severe stress. The telecom example is sometimes compared to the current energy situation: Debt-financed growth resulting in a disproportionate weighting in the high-yield index.
One of the differences (other than size -- telecom/tech accounted for about 40% of the index vs. 18% for energy) is the nature of the assets, which has implications for restructuring. The telecom bust of the 1990s was partly a regulatory arbitrage, and the competitive carriers that sprang up to challenge incumbents had raised debt based on flimsy business models. Telecom assets often had very little residual value and limited interest from strategic or private equity buyers. The distressed energy companies of today have decent assets, but they also have capital structures predicated on oil prices staying above $75/barrel. Most of these companies will reorganize, and the assets will find new owners and balance sheets. Life will go on.
Still, if oil stays lower for much longer, energy defaults may rise to over 10%, and the headline numbers may cause an acceleration of retail flows to leave the high yield market, resulting in broader market weakness. This occurred in December, 2014, an event we viewed as a buying opportunity, particularly of lower-rated consumer-oriented, technology, and healthcare issuers.
The fundamentals for high-yield issuers (outside of energy/commodities) remain solid as leverage remains well below pre-crisis peaks, operating margins are at record levels, free cash flow generation is healthy, and oil price declines are beneficial. Also, most high-yield issuers are domestic-oriented, and the strong dollar will not be a material headwind for them. Rather than a large number of energy defaults causing the high-yield market to trade off, the more likely transmission mechanism of sustained sub $50 oil is through emerging market stress, similar to the late 1990s.
Key Takeaway: Distress in a large sector can often cause spreads to widen, but as long as a recession is avoided, the broader market is likely to rally subsequently. Given our constructive view of the domestic economy and the net positive impacts of lower oil prices, we think the high-yield market will continue to decouple from the distressed energy subsector.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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