It took less than a year for the bond market's biggest villain to turn into its biggest hero.
The U.S. energy junk-bond market lost $56.7-billion (U.S.) of market value in seven months last year. Average yields on the debt soared as high as 21 per cent. Almost everybody hated these bonds. The only question was how much the pain would spread through the rest of the $6.6-trillion U.S. corporate debt market and beyond.
The pain didn't spread very far. Oil prices bottomed in February and then surged, and suddenly everybody loved energy junk bonds again. The debt gained almost 40 per cent, or about $53-billion of market value, from March through July. It now pays about the smallest amount of extra yield over the broader high-yield bond market since June, right before last year's meltdown.
But now that so many investors are comfortable with energy junk debt again, it's worth taking a moment to ask: Has the enthusiasm gone a little too far? And the answer is probably yes. Oil prices are still lower than they were in July last year. While prices have risen from the lows, they're still not high enough to prevent more drillers and explorers from going bankrupt. And energy prices could fall again.
Meanwhile, even though there's been a lot of shuffling of names in the energy-debt index, with some investment-grade companies getting downgraded to junk and low-rated firms going bankrupt, the net result hasn't necessarily left the energy index in a better place. In fact, as longtime high-yield bond analyst Marty Fridson noted, by one measure the credit quality of these bonds has actually deteriorated. About 40 per cent of bonds in the U.S. energy high-yield index carry the lowest ratings, almost twice as high a proportion as in June 2014, noted Mr. Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC. The composite rating of the $216.5-billion U.S. energy high-yield bond market is about the same now as it was a year ago, according to Bank of America Merrill Lynch index data.
It seems as if traders are simply disregarding the possibility of another decline in oil prices, or another wave of bankruptcies, in their zeal to capture any extra yield they can find. They justify this by telling themselves that the shakeout has already happened and that the energy market is in full recovery mode. But the truth is much more complicated.
Oil prices are notoriously unpredictable, subject to haphazard global political forces and a cloudy macroeconomic outlook. It seems investors are demanding a remarkably small premium for all those uncertainties. It's not hard to see energy junk bonds becoming outcasts again.