High Yield Hijinks

About: iShares iBoxx $ High Yield Corporate Bond ETF (HYG), Includes: JNK, USO
by: The Heisenberg

Were you in high yield credit last year? Yes? Good for you - you made a small fortune.

But how will the space treat you in 2017?

I don't know, but I do know what it all depends on.

Six espressos and around a dozen total posts later, it's time for me to enjoy that narrow, early evening window between the US close and the moment when my inbox starts to chime with Bloomberg e-mails documenting the latest developments out of China.

It's during this precious two hour respite that I'm generally free to reflect on whatever I didn't have time to think about while markets were open. Sometimes I'll use this brief reprieve to read or take a walk, but more often than not, I find myself writing.

Throughout the day I keep a list of notes and headlines that I think may have some incremental value when it comes to enhancing my understanding of some market dynamic I happen to be following. Generally I'll come back to my list just as the sun is going down and decide if there's anything there worth expanding on in a post.

Today I found some interesting stats on high yield (NYSEARCA:HYG) in 2016. I also bookmarked a bit of highly amusing commentary from Citi on HY energy (a favorite punching bag of mine despite the fact that last year the sector punched back, nearly KO'ing skeptics like myself in the process).

On Monday evening I spent some time explaining the mental framework I use to assess the HY energy space. In short, I think there are still a lot of weak hands that haven't yet been shaken out. Essentially, my contention is that the central bank-inspired hunt for yield effectively chased investors further down the quality ladder until finally, when there was nowhere else to go, they resorted to buying into secondaries. From the perspective of the companies selling shares, they had lost access to bond markets and their revolvers were being cut, so it was follow-on offerings or nothing. And by nothing I mean bankruptcy.

But really, there shouldn't have been any interest in these deals because let's face it, the companies selling the shares should have already been out of business. But wide-open capital markets courtesy of Fed largesse gave new meaning to the phrase "it ain't over 'till it's over."

It turns out that not even two years of subdued crude (NYSEARCA:USO) prices could put US production out of business. Of course it doesn't matter because the entire charade is self-defeating. As US production comes back online it will sow the seeds of its own demise by offsetting OPEC production cuts. This is how QE and rock bottom rates create disinflation (the exact opposite of central banks' stated intent). Insolvent businesses that are allowed to stay afloat contribute to overcapacity - and overcapacity contributes to deflation.

Of course none of the above means much to anyone who rode last year's HY (NYSEARCA:JNK) rally to the moon. So exuberant were markets that HY energy credit actually outperformed the XLE (which didn't do so bad in its own right):

(Chart: Goldman)

The same was true of HY and stocks more generally:

(Chart: Goldman)

Now if you ask me (and since you're reading this, you are implicitly asking me), the worst is still ahead of us despite the fact that HY defaults hit a post-crisis high in 2016 (for more on the cycle, see here).

Given that HY energy companies have been forced to resort to issuing new shares to raise capital, let's take a look back at HY bond sales (so, a proxy for market access) in 2016. As Bloomberg noted on Tuesday, "high yield issuance was down 6.8% y/y [for the year] with 363 deals for $230 billion in pricing, the lowest yearly volume since 2011." The culprit? Why, falling oil prices of course. Here's more, again via Bloomberg:

  • Relentless plunge in oil impacted issuance early in the year as 1Q supply was down 57% y/y with January supply the lowest since 2009; February was also the lowest since 2009 with $9.355b
  • As oil surged 35% crossing the $50 mark for the first time in 12 months, supply gained momentum in 2Q with 110 deals for $81.7b pricing
  • Rapid surge in oil prices, together with big net inflows into retail funds with Lipper reporting the biggest inflow on record in early March followed by four consecutive weeks of inflows, accommodative global central banks beginning in 2Q and bullish stocks with S&P 500 setting new record throughout the year boosted high yield sentiment
  • Yields dropped steadily as Bloomberg Barclays High Yield Index hit 16-Mo low of 5.98% in October as oil was at YTD high of 51.60; yield hit a multi-year high of 10.10% in February as oil dropped to 13Y low
  • Spreads tightened to a 2Y low in December after multi-year wide of +839 in February

And for the visual learners out there, here are some charts that illustrate some of the bullets:

(Charts: Barclays, my additions)

What's clear from the above is that access to the bond market is entirely dependent upon oil prices. Which is common sense. My questions for 2017 are i) will a stronger dollar and OPEC's tendency to cheat on production cut promises undercut crude? and ii) if so, and demand for new HY issuance subsequently dries up, will there still be any investor appetite for follow-on stock offerings assuming rising risk-free rates make riskless assets attractive again?

I don't know the answers, but as I like to say, the questions are sometimes more important.

And now for the punchline(s). Citi may not know how HY energy will ultimately perform in 2017, but they thought long and hard about what will drive said performance (or underperformance). Here's what they came up with (my highlights):

We still expect the overall performance of [the HY energy] sector to be tied to the performance of commodities, but given that Citi's HY Energy Index is currently yielding 5.43% versus 5.68% at the beginning of 2014, we think the correlation between oil prices and HY energy will not be as significant in a rising oil price environment, but highly correlated if oil prices decline.

There you go. Falling oil prices will likely hurt oil producers. Who'd have guessed?

And in case you weren't amused enough by the analysis, Citi's analysts came up with what I'm sure they thought was a really clever, pop culture-infused title for the note...

And to think, someone's getting paid big money to come up with this stuff.

Happy trading.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.