High Yield and Contagion
It's been a brutal 15 months for energy and credit investors since OPEC announced they would not scale back production in October 2014. Around the 1-year anniversary of that decision, we published a piece called 'Energy Market Roller Coaster Continues…' where we highlighted many of the stresses building up in energy and credit markets. At the time we published the piece, spot oil was trading around $45-46/barrel; now it is trading below $30 with few signs that price pressures are abating. Speaking at the Stifel Transport & Logistics Conference, famed distressed investor Wilbur Ross affirmed that Saudi Arabia, OPEC's largest and lowest cost oil producer, is committed to a maintaining market share despite 2 million barrels/day of global overproduction (Exhibit 1) and with Iran and others ramping up production. According to Ross, the Saudis are in this for the long haul as evidenced by
1) Divestment of some international investments
2) Reduction of domestic fuel subsidies and programs
3) Borrowing money for the first time
4) Openly discussed sale of Aramco and
5) Rebuffed construction constraints.
Exhibit 1 - Global Supply Exceeds Demand by 2.1 MM Barrels/Day
Bulls point to this global supply imbalance correcting itself over the next few years as lower North American production will hit global supply in the years to come (Exhibit 2) even though global demand continues to rise despite the slowdown of many emerging market economies. However, energy consultant Wood Mackenzie estimates that only 0.1% of global crude output has been shuttered by cheap oil as 'cash costs' for operating existing wells make many unprofitable wells viable from a cash flow perspective. At this point, it is largely the high cost Canadian oil sands and aging North American wells that will likely see shut-ins unless we have a protracted decline in oil prices. That is why some strategists are now calling for oil prices to drop to the teens.
Exhibit 2 - Baker Hughes Oil/Gas Rig Count approaching 2001 levels
Despite the well-known weaknesses affecting energy market pricing, bears continue to press their bets as evidenced by record high net short interest in NYMEX futures (Exhibit 3).
Exhibit 3 - Record Short Interest in NYMEX Futures
Last year, energy fundamentals had remained largely confined to the energy sector and investments tied to energy ranging from cyclical equities and emerging markets to master limited partnerships and corporate credit. This year, we're starting to see indiscriminate selling as investors are bracing for broader contagion risk affecting all market segments. Through February 8, the S&P 500 is down 9.1% while MSCI EAFE is down 10.3% and MSCI Emerging Markets down 7.5%. Interestingly, within the U.S., the hardest hit sectors are some of last year's leaders such as consumer discretionary (-12.0%), health care (-11.8%), and technology (-11.8%) while energy (-6.2%), industrials (-6.7%), and materials (-8.8%) have outperformed. And the S&P/GSCI Commodity Index is only down 9.9%, roughly in line with global equities. Those hoping to hide out in high quality and momentum have actually underperformed riskier, out-of-favor segments. The only true hiding places have been in low volatility sectors such as utilities (+7.2%), telecom (+8.6%), and consumer staples (-1.9%). And unicorns are turning more mythical than real as the FTSE/Renaissance IPO index has dropped 23.7%.
Even though the energy sector has held up relative to the broader market, the same can't be said for other energy-related investments. The Alerian MLP is down 22.3% (see this article discussing how management changes and the potential bankruptcy of Chesapeake Energy have led to significant sell-offs in two of the largest pipeline companies - Energy Transfer and Williams). Bulls on the MLP space maintained that the fixed price contracts signed with producers made pipeline operators largely immune to oil price fluctuations. However, these contracts will certainly come under review during bankruptcy proceedings that will weigh on future MLP distributions.
Banking Sector - The New Ground Zero of Contagion Risk
If someone could have predicted that the energy sell-off that started in October 2014 would have led to German megabank Deutsche Bank (NYSE:DB) trading at a record low and at 0.3x book value, then that 'someone' deserves all your money (kidding aside - there were some strategists warning of potential contagion risk affecting the broader market). European banks have been under pressure from regulatory authorities for past misdeeds (i.e. LIBOR price fixing) and lack of profitability to build up capital reserves to meet heightened capital requirements. The concern with DB is that these pressures have threatened the bank's near-term funding commitments prompting German's Finance Minister Wolfgang Schauble to voice an 'everything is A-okay' vote of confidence on DB. European banking stress is but one sign that what had appeared to be 'contained' in 2015 is now starting to spread like the flu. Indeed, the worst performing sector within the S&P 500 is financials which are down 14.4%. Incidentally, the spike in European financial stress (Exhibit 4) will help ensure that the European Central Bank will aggressively expand quantitative easing at the March update.
Exhibit 4 - European Financial Stress Back on the Rise
Economist/Strategist Rich Farr from Merion Capital Group made this astute observation (2/9/2016 Global Economic Strategy) on what European financial sector stress is signaling:
"The current thinking on DB is that it could run into liquidity issues in 2017 if Europe continues to deteriorate and legal costs mount. We are not aware of any imminent capital threat to DB, or other major European banks. However, we must respect the market's ability to accelerate such problems when the bears identify a target. So, certainly risks are rising for European banks, as evidenced in rising costs for credit protection.
In the case of DB, recall that DB is a German bank and the Germans continue to pose the biggest resistance to Mario Draghi's plans at the ECB. If DB is going to run into some trouble next year, German opposition to more QE falls. We can assume that political pressure is already mounting in that regard.
If German opposition to more QE falls, then the ECB has room to get aggressive with QE and negative rates next month ... possibly going further into negative territory and further out on the curve.
…If regulatory/legal costs stand to put European banks at risk, we can be assured that politicians are going to rein in the regulators for the time being. It hasn't gone unnoticed to us how long it took to address prior Wall Street transgressions (LIBOR, CDOs, Gold rigging, FX manipulation, etc.). No major fines or penalties were assessed until after the banks had shored up capital. That wasn't a coincidence....it was by design."
Although U.S. bank credit costs have remained somewhat stable (at least versus Europe), the concern for U.S. banks is whether they've properly provisioned for energy-related loan losses. The sell-off in equities suggest that investors expect earnings growth headwinds stemming from catch-up capital provisioning for such loan losses. Of broader concern is whether banks will start to see weakness in other loan segments such as auto loans and subprime housing.
So All this Suggests Buying High Yield?
This brings us full circle to U.S. high yield which is down 3.9%, about in line with what one would expect given its equity market sensitivity. Despite the single digit loss, the U.S. high yield market trades at stressed levels as indicated by credit spreads over Treasuries (Exhibit 5). Even investment grade credit spreads (Exhibit 6) continue to widen out (as an aside, investment grade energy credit probably presents a better risk-adjusted reward than high yield energy given the former's stronger balance sheets to weather a protracted downturn).
Exhibit 5 - High Yield Spreads Continue to Widen
Exhibit 6 - Credit Contagion Spreads into Investment Grade
A good rule of thumb is that when a bond is priced to yield over 1,000 basis points versus Treasuries, then it is likely that bond will go through some form of restructuring (in other words, you're not getting that yield but a workout-adjusted return assuming you have the patience to wait through the ~2-year workout period). At over 1,400 basis point spread, the market is pricing in a sector-wide bust for high yield energy; what the markets fear is the unknown contagion effects that bust will have on other segments, particularly large financial institutions that leant heavily to this sector.
Yet, for tactical investors, high yield valuations present a compelling entry point at least as indicated by looking at historical spread levels versus forward returns. As Exhibit 7 indicates, high forward returns come from periods of high stress in the market (when high yield spreads are north of 800 basis points - as of 2/8/2016, we reached that point). Investors who focus on the total return appeal of high yield bonds should be aware that much of this total return comes from capital appreciation during periods of wide spreads (or maximum fear). Your best chances of earnings high total returns come from at points where it becomes the hardest to hold your nose and invest in the sector. In other words, buying high yield at these levels requires significant intestinal fortitude.
Exhibit 7: At 800 Basis Point Spread, High Yield is a Buy but Only for Those with an Iron Stomach
High Yield Is an Asset Class to Rent Not Own
Traditional U.S. high yield does not warrant a strategic (read long-term) allocation within fixed income portfolios, particularly when they serve to diversify and dampen the market risk stemming from equity portfolios within outcome-based asset allocation programs. The historical correlations bear this out as high yield exhibits a higher correlation to equities than fixed income (Exhibit 8). Investors who thought they were getting 'fixed income' from high yield ended up with 'equity beta in sheep's clothing.'
Exhibit 8 - High Yield More Correlated to Equities than Fixed Income
Ultimately, high yield bonds share much of the market risk inherent in equities as high yield borrowing largely serves to fund future growth initiatives (or fund large dividend payouts for private equity investors). Unfortunately, high yield investors do not share in the upside if these growth projects bear fruit but share most of the downside should they don't. That asymmetric risk profile should be reflected in the underlying yield offered to investors. When spreads are narrow, investors are hardly compensated for taking on this risk. When spreads are wide, high yield bonds reflect more of an out-of-the money call option on future prospects. It's an area that investors should tread carefully.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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