The plunge in commodity prices is driving significant changes in the risk profile, and investment opportunities within, the global high-yield credit market, says Fraser Lundie, Co-Head of Credit and Senior Portfolio Manager.
High-yield evolution: It has not been a quiet summer for investors in high yield credit markets. The main reason for this has been the continued stress in commodity-related sectors. The commodity price falls of the last 12 months have been well documented, as have the consequences for equity and bond prices. However, something that has perhaps been underappreciated by investors has been the rapidly evolving shape of the global high yield market.
Heightened commodity risk: A combination of sovereign-related credit downgrades, in pressured countries such as Brazil and Russia, and those that are company-specific, in names such as Transocean, has fuelled growth in the basic industry and energy sectors of the high yield market. The changing composition of the BofA Merrill Lynch Global High Yield Index highlights the significant increase in the risk contributions from these sectors compared to a year ago (see figure 1). This is not adequately reflected by the notional market weight of these issuers, as this does not measure duration or credit quality. However, using duration times spread (DTS) takes these elements into account. On this measure, energy and basic industry together provide 36.7% of the risk in the market – a 40% jump from a year ago.
Figure 1. The basic industry and energy sectors now contribute 40% more risk compared to a year ago
Source: BAML, Hermes Credit
Divergent performance: These sectors have underperformed, both in equity and credit, in recent weeks – with resultant outflows from high yield credit funds. However, we expect diverging performance within these sectors from here, as stressed companies begin to engage in much more bondholder-friendly corporate activity at the expense of near-term equity performance. For example, both Chesapeake Energy and Linn Energy decided to eliminate dividend payments and aggressively cut capital expenditure – with the latter going a step further and opting to buy back up to $650 million of its own bonds in the open market during Q2 2015. Linn’s stock fell by more than 25% on the announcement, while its 2020 bonds bounced 3-5 basis points (bps). Chesapeake’s share price was also down 10% on this action, but its bonds stabilised after experiencing significant stress in prior weeks as natural gas prices continued to sell off. These actions may still not be enough to ward off the troubles faced by these companies amid weak commodity prices, but they indicate what is likely to become a trend.
Flexibility required: This change reinforces the importance of accessing the high yield market through a truly global mandate. Look at the European high yield market: it currently has a negligible exposure to energy, a major reason why the market currently offers a yield of 4.35% to the 7.25% of the global market. Navigating in and out of such sectors and geographies requires nimbleness and flexibility.