Investors, myself included, continue to marvel at the low volatility regime. Measures of equity and bond volatility remain at or near all-time lows. As I’ve discussed in previous blogs, tight spreads and benign credit conditions support a low volatility environment, as illustrated below.
Year-to-date, high yield and other spread products continue to produce solid returns. In the case of U.S. high yield, this is a bit surprising given the drop in oil prices, down around 10% year-to-date. After all, it was only 18 months ago that a plunge in oil prices, coupled with fears over Chinese growth, sent high yield plunging and credit spreads soaring. What has changed?
As it turns out, quite a lot. There are a number of reasons why high yield markets have been more resilient to lower oil prices:
1. Global economy on solid ground
Unlike early 2016, when investors fretted over the potential of China dragging down the global economy, most recent economic indicators point to stability.
2. Better quality in energy issuers
Today, low rated companies (CCC and below) make up a smaller portion of high yield energy issuers.
3. Smaller share of the high yield market
High yield energy is now 13% of the Bloomberg Barclays High Yield Index as opposed to 17% in early 2016. That is roughly a 25% drop in its contribution to high yield spreads.
4. Improved term structures
Energy issuers are less dependent on rolling over near-term debt. And as with all high yield issuers, companies continue to benefit from still low interest rates and easy financial conditions.
5. Lower production costs
According to research from Barclays, high yield oil and gas exploration and production (E&P) companies have slashed breakevens costs by approximately 30%, to roughly $50 per barrel. This is particularly true for those E&P firms centered in the Permian Basin in West Texas, where production costs tend to be the lowest in the continental United States.
All of this suggests that high yield is not as vulnerable to lower oil prices as it was in early 2016. Work from my colleague Miguel Crivelli confirms this view. Based on his research, when West Texas Intermediate (WTI) is between $40 to $50, high yield spreads are likely to be about 45% lower than what would have been expected based on the pre-2017 relationship. Put simply, high yield energy spreads are less sensitive to changes in oil today. For every dollar increase in oil prices, high yield spread in energy only moves two-thirds as much as it would have before 2017, when oil prices were in the same range.
That said, the fact that high yield has become more resilient does not mean the sector is now agnostic to the price of oil. At some price point, a good portion of energy issuers will find themselves struggling to service their debt. A best guess: Oil at $35 per barrel could entail not only a significant widening of spreads for energy issuers but potential contagion to the rest of the asset class.
This is important. One factor that has kept markets aloft year-to-date has been well behaved credit markets. As experienced in early 2016, credit contagion could derail equities as well. The good news today is that the pain point, i.e. when high yield succumbs to lower oil, is a good deal lower than it was. This provides some cushion for both credit and equity markets.