It has been a horrible few months for the commodity complex (oil, natural gas, met coal, thermal coal, copper, aluminum, steel, gold, etc.), as price declines have led to significant equity and bond market underperformance. The pain has been particularity acute in the high yield credit market, where a majority of energy and metals/mining bonds are down 10 to 40 points since May. These two sectors are the only two negative returning industries in the JP Morgan High Yield Bond Index this year.
The default cycle has already started. The energy and metals/mining sectors represent about 70% of default and distressed exchange volume in 2015 and account for over three quarters of the high yield universe trading below $70, which is considered distressed-level bonds. According to a recent Morgan Stanley report, the market-implied 5-year cumulative default rate for high energy companies is about 30%. While many companies have adequate liquidity into 2018, and management teams have aggressively reduced capex and operating costs, the market is discounting low oil and natural gas prices for an extended period of time. Moreover, future recovery rates are being impacted by recent second lien bond deals, which subordinate unsecured note-holder claims, and there are expectations for more to come.
During the first quarter of 2015, oil appeared to find a bottom and started to grind higher. While still down 50% from its peak, the idea of stabilization caused the market to rally. However, after peaking in the low $60s in May, the price of oil has subsequently declined 25%, mainly due to weakness in China and nervousness over the Iran nuclear deal. Also, despite an almost 60% decline in oil rig count over the last year, domestic production remains stubbornly high as companies reduce costs, increase productivity, and tap additional liquidity sources.
In addition to the recent pullback in oil, two other factors appear to be influencing bond prices - investor fatigue and positioning. Sentiment is washed out, particularly after the first quarter's head-fake trade, and many buy-side firms already own a lot of energy paper. With buyers now having more limited investment capacity, bond prices react severely when larger holders attempt to pare their exposure.
Key Takeaway: Trying to call a bottom on oil prices feels a lot like trying to catch a falling knife. It's likely to be painful no matter where you grab it, so deciding when to grab can be tricky. I was nibbling on what I perceived to be higher-quality high yield energy at the beginning of the year, and what looked to be a good move in the first quarter now looks premature. Still, I feel there is value in some of these credits yielding over 7% and think a number of them can survive with oil in the $45-55 range.
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.
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