Energy-related bonds are getting crushed. Since oil hit is recent high on June 20, the Merrill Lynch High-Yield Energy Index has dropped 11.6%. The average dollar price of junk-rated energy bonds is now $89.8. This has dragged down high-yield bonds in general, partially because energy is the largest sector within most high-yield indices (and thus portfolios), but also because of worries about what the precipitous drop in oil prices means for global growth. If you can afford to be selective, you can find some great value in high-yield bonds today.
First, let me say that there are very real worries about energy-related defaults. Over the last decade, non-traditional oil and gas drilling has dominated capital investment in the U.S., with a fair amount of this being funded in the debt markets. Historically, default spikes have typically emanated from sectors where there has been rapid growth of new issuers. This is logical, since the last few projects to get funded during a boom are probably the most marginal, and thus when the cycle turns are the most likely to default. In energy, for instance, it is probably the case that earlier projects have better economics, therefore, they can withstand a lower oil/gas price, whereas later projects (taken as a group) are more vulnerable.
It is also possible for there to be a localized default spike in energy. Oil and gas prices have moved lower entirely on global demand during a period where U.S. growth appears to be accelerating. Indeed, on a net basis it is likely that lower energy prices are a positive for U.S. growth, as it should give consumers more budget to spend on other goods. So, it very well could be that one sector's loss is other sector's gain.
The default level could get ugly. An analyst with J.P. Morgan recently estimated that if oil stays at $65 per barrel, 25% of the high-yield energy universe could default over the next three years. If energy makes up 14% of the high-yield universe, this is meaningful for all high-yield bonds.
However, I believe plenty of babies are thrown out with the bathwater here. I'm sure there are some in energy specifically. But you don't need to be a hero. There is no reason to expect systemic defaults unless the economy as a whole is going to slow down. There are definitely companies with mostly U.S., non-energy exposure. Here's the top five non-energy, U.S.-based holdings in iShares iBoxx $ High Yield Corporate Bond ETF (HYG) with price change the last 30 days.
• Sears (SHLD) 7.875% due 2023: Down 4%, now yields 7.8%.
• First Data 12.625% due 2021: Down 2%, yields 5.8%
• Reynolds Group 5.75% due 2020: Down 3%, yields 5.2%
• HCA (HCA) 6.5% due 2020: Down 2%, yields 4.3%
• Community Health (CYH) 6.875% due 2022: Down 3%, yields 5.9%
So you have a retailer, a payments-processing firm, a packaging company and two hospital operators. At least they are no worse off, and arguably most are better off, for oil being lower. Meanwhile, the U.S. economy shows continued signs of strength. I don't like Sears' business model any more than you do, but they aren't worse off for oil dropping and adding more disposable income for consumers. It surely isn't worse off for the economy adding 320,000 new jobs last month.
I'm not indiscriminately buying (i.e., I'm not actually buying Sears bonds) but if there are names you know well, now is the time to be adding on the credit side. Remember that good investment opportunities don't feel good at the time. I see a good opportunity in credit, and we're adding to risk here.
At the time of publication, Graff was long HCA and Reynolds bonds, although positions may change at any time.