Market Views: Fixed Income
Coronavirus and an oil price shock: a perfect storm for high yield debt?
Saudi Arabia’s decision to sharply increase oil supply resulted in the largest drop in the oil price since 1991, with the price of crude oil falling below $35 per barrel. This has had a significant knock-on effect on the credit market. Specifically, the option-adjusted spread on the US high yield (HY) index, in which energy is the largest sector, widened by more than 100 basis points (bps) on Monday, the sort of move last seen at the height of the global financial crisis.
As we wrote earlier this week, Saudi Arabia’s actions may eventually result in supply destruction and significantly higher prices. However, in the near term, the reality is that a lot of cash-strapped US shale producers will struggle to survive with the oil price in the low thirties. This, in addition to the uncertainty surrounding the ultimate economic damage and disruption of coronavirus, makes for a challenging outlook for HY.
The upside of the sharp sell-off is that valuations have improved significantly. Now the question is whether spreads are wide enough to compensate investors for possible defaults. While spreads are indeed looking more attractive, we think the priority for investors at present is to avoid possible value-traps.
How hard has US HY energy been hit?
The ICE BofA US HY Index spread stands at 661bps (as of 11 March), more than doubling since November 2019 (Figure 1). The spread of the US HY energy sector is a whopping 1579bps. It is now higher than during the financial crisis and just shy of the 2016 peak. Excluding energy, the index spread is less elevated at 533bps, but the difference between energy and the wider index is not as large as in 2016, as other sectors have seen sharp spread widening too.
In the three highly exposed sectors, gaming (e.g. casinos), leisure and airlines, the spreads are now wider than in 2016 at 613bps, 899bps and 957bps respectively. Even though these three sectors make up just 3.8% of the index, they could be a bellwether for other sectors where the reaction has been more muted, should the virus situation escalate.
The energy sector, at 14%, is the largest sector in the US HY index. Consequently, the fate of energy companies will influence the performance of the broad HY market. Some sectors will benefit from lower oil prices, for example airlines and the broader consumer sector. However, as things stand, the fallout from coronavirus is likely to far outweigh the benefit.
How big will be the damage in the energy sector?
According to the Federal Reserve Bank of Dallas, the breakeven oil price of US shale is $48-54 dollars per barrel. Being one of the highest marginal cost producers, it is logical that the shale companies are first to cut production. Arguably, it is Saudi Arabia’s main goal to drive high cost US shale producers out of business. However, the consequences are much broader.
The oil price is now below the operating cost of the industry for the all non-OPEC producers. The largest integrated oil companies need to achieve at least $35 a barrel to sustain cash operating costs. This could lead to significant supply destruction and eventually higher prices, although the timeline is uncertain.
A possible lifeline for oil companies in the near term is that OPEC’s capacity to wage an extensive price war is limited due to high fiscal needs. Goldman Sachs estimates that the average OPEC fiscal breakeven, the point where oil revenues cover expenditure, is at around $80 per barrel. This could force OPEC and Saudi Arabia back to the negotiating table sooner rather than later.
Whatever the case, the US shale industry faces considerable uncertainty. The longer prices stay low, the greater the probability that a number of shale producers will run out of cash and default. It’s true that there is not an immediate refinancing headache for many energy companies. However, defaults do not only occur when issuers fail to redeem bonds, but also when they miss coupon payments.
Expected defaults in the energy sector
Given the large market move, the potential negative consequences for the energy sector could already be reflected in bond prices. Even before the oil price collapse, the annual default rate of the US HY energy sector was running high at 13.4% (Figure 2, blue line).
Energy sector bonds are either trading at extremely distressed levels or pricing in defaults. As of 11 March, 27% of energy bonds are trading at less than 50 cents to the dollar and 15% are trading at less than 30 cents (Figure 3).
In 2016, the rolling 12 month default rate in energy peaked at 23.3%, while the recovery rate bottomed at 20%. A repeat of these levels today would imply a maximum annual loss of 18.7% - calculated as default rate x (1 – recovery rate) - above the current spread of 1579bps. It is worth noting that distress levels were also greater in 2016 than they are today (Figure 3). Furthermore, HY energy fundamentals are worse than in 2016 – leverage is higher and interest coverage is lower. Energy spreads could certainly widen further.
Situation outside the energy sector
Defaults outside the energy sector have been scarce in this cycle (Figure 3, green line). Broadly stable conditions and low interest rates have encouraged companies to increase debt levels. Excluding energy and financials, the US HY debt to EBITDA ratio at 4.5x is 50% higher than in 2007 (Figure 4). At the same time, low global yields have allowed companies to comfortably cover interest payments.
However, with the spread of the coronavirus and increased uncertainty, this could change, with liquidity, cash held on the balance sheet, becoming key. Unfortunately, cash levels have fallen in the last two years in US HY (Figure 5). The impact of coronavirus may well force companies to spend down their cash reserves, ultimately leading to rising defaults outside the energy sector, especially if the shock turns out to be more than transitory.
High yield credit spreads have increased significantly in recent days. While on the face of it, this would suggest that it is a more appealing time to invest, there are significant risks in a number of sectors and companies. Some companies will fail and blindly buying the market is unlikely to be a sensible approach. Against this backdrop, it is more important than ever to be selective and avoid falling into value traps – some bonds will turn out to be cheap for good reason.