Oil prices have fallen from their last peak of $107 per barrel (b) in June 2014 to around $30/b now – a decline of over 70%. Not so long ago, the reaction to such a development might have been positive with markets anticipating both consumer and corporate gains. This time, however, markets have been rattled.
Spreads of U.S. high-yield debt over U.S. Treasuries have been widening for months. The link with falling oil prices, as is shown in the chart, is understandable. During the shale boom, energy became the single largest sector in the U.S. high-yield market, at its peak accounting for 15.5% of the bonds issued. At current market values, however, that share is already down to about 11%. Exploration and production only accounts for 3.5 to 4%, including bonds which were recently downgraded from investment grade.
High-yield issuers in the United States are certainly having an increasingly difficult time raising money. Less accessible financing combined with the low oil prices is increasing expectations of default. The market now appears to be pricing in high rates of default for the market in aggregate. However, this overall widening of spreads looks excessive, not least because of energy issuers’ relatively small and declining share of the market. At some point the cheapening of this asset class will create opportunities in the non-energy segment of the U.S. high-yield market.
All this also obscures the fact that for the U.S. economy as a whole, including its riskier borrowers, cheaper oil should be a net positive – even though it will take a while for the benefits to come into focus, whereas the problems are more immediate. Against this background, we remain positive on U.S. investment grade in the longer term. In the short term, however, we expect forthcoming quarterly reports to show continuing trends of low earnings growth, slowly increasing leverage and weakening coverage measures. Key credit metrics (on a net-debt basis) remain in the middle of the historical range, but this provides little comfort as risk aversion increases. The recent spate of primary issuance has left support for the secondary market lukewarm at best.
So even though the long-term negative effects of lower oil prices may have been overstated, continued caution on both U.S. high-yield and investment-grade markets still looks advisable for now.
U.S. high-yield spreads have widened since oil prices started to fall in mid-2014. Current spread levels appear to indicate a very high expected cumulative default rate over the next five years.