Beware Further Pressure in the Energy Market
Faltering growth expectations around the world have raised fears about the sustainability of the current U.S. economic expansion. The economic data, though, suggest that these fears are largely unfounded. U.S. growth appears insulated from the slowdown in other countries thus far, evidenced by the U.S. economy growing at 5 percent in the third quarter of 2014—its quickest pace in 11 years. Unfortunately, U.S. equity and credit markets were not safe from the risk aversion that drove volatility during the second half of the year.
The global macroeconomic picture is changing, and investors must guard against vulnerabilities. One of those vulnerabilities has been plunging oil prices, which dims the outlook for the energy sector and has caused spread widening across investment-grade and high-yield U.S. fixed-income assets. While we believe risk of defaults in energy is limited in the near term, now is the time to monitor significant exposures that may cause underperformance in potentially worst-case scenarios.
· Volatility in leveraged credit markets continued through the end of the year, with the Credit Suisse High-Yield and Leveraged Loan Indexes posting a loss of 1.6 percent and 0.4 percent in the fourth quarter, respectively.
· While the U.S. economy remains strong, equity and credit markets are becoming increasingly susceptible to certain macro-driven risks, such as the decline in oil prices. These risks are likely to continue to play a role in driving returns in 2015.
· Weak supply and demand dynamics for oil over the next 12 months heighten the risk of further losses in the energy sector. The most prudent course of action would be to stress portfolios for the possibility that oil might fall further, to below $40 a barrel.
The Bright Side and the Dark Side
U.S. growth appears to have decoupled from the rest of the world. The third quarter’s 5 percent U.S. GDP growth — the fastest pace in 11 years — signals that the U.S. economy is doing very well. Deeming growth sustainable, the Fed formally ended its quantitative easing (QE) program in October, and all eyes are now on economic data—primarily inflation and employment figures — that would prompt the Fed to raise rates in 2015.
The outlook is not so positive elsewhere. The battle against deflation in Europe forced the European Central Bank (ECB) to announce its own form of QE via purchases of asset backed securities (ABS) and covered bonds. The consensus appears to be that in its current form, the program is insufficient to avert a slowdown. Doubts remain over whether there are even enough assets for the ECB to buy that would allow it to expand the balance sheet and spur lending in the struggling economy. The next step for the ECB may be to buy sovereign bonds, but it is not yet clear if the European court will allow such purchases. The only notable positive for Europe over the past year has been the devaluation of the euro, which fell by 13 percent against the U.S. dollar between May and December. A weaker euro makes exports more competitive, but still will not be enough to boost inflation in the region.
While markets were already anxious over Europe’s struggles and the potential impact of a stronger dollar on U.S. company earnings, Japan relapsed into recession, with it’s GDP contracting by 7.1 percent year over year in the second quarter and 1.6 percent year over year in the third quarter. This drove the Bank of Japan to announce it would expand its asset purchase program in 2015. China also faces slowing growth as financing costs remain high for smaller companies, forcing the People’s Bank of China (PBOC) to cut benchmark interest rates for the first time since July 2012. Slowing global growth has translated into expectations of weaker demand for oil in an already oversupplied market, which contributed to oil’s 49 percent decline in the second half of the year with West Texas Intermediate ending the year at a five-year low of $53 a barrel.
The bright side to declining energy prices is that it leaves more money for consumers to spend on other goods. We have already seen some of this in the data. American consumer confidence reached new post-recession highs, and retail spending for the month of November comfortably beat expectations. Overall, this should be positive for consumer-related companies with primarily domestic operations.
The dark side is most evident in the energy sector thus far. In the second half of 2014, energy-related investment-grade bond spreads widened by 73 percent, high-yield energy spreads widened by 106 percent, and the energy component of the S&P 500 lost 18 percent on a total return basis. Unfortunately, the adverse effects of declining oil prices may not end there. Current valuations in both equity and fixed-income markets appear to be discounting a relatively rapid recovery in energy prices, which we believe to be highly unlikely. The risk of an economic contraction across major oil-exporting nations, such as Russia, could create an oil price-induced negative feedback loop that would stifle global growth, weaken foreign currencies further against the dollar, and negatively impact earnings for leading multinational companies.
From an investment standpoint, U.S. assets continue to look attractive. With global central banks easing or engaging in their form of QE, global yields remain anchored and are driving investors into U.S. markets. But we are wary of the potential for a setback in U.S. equities as certain factors, such as oil prices and currency fluctuations, drive markets to aggressively discount valuations for some sectors more than others.
2014 Leveraged Credit Performance Recap
Risk Aversion Takes Over
After a strong start for leveraged credit in the first half of 2014, significant volatility in the second half ultimately culminated in the weakest performance since 2008 for high-yield bonds and since 2011 for leveraged loans, with annual returns of 1.9 percent and 2.1 percent for the Credit Suisse High-Yield and Leveraged Loan Indexes, respectively. High-yield bond spreads widened by 128 basis points over the year, ending the year at 564 basis points, while loan discount margins widened by 70 basis points and ended the year at 558 basis points. Below are key highlights in leveraged credit for 2014, which sets the technical backdrop that drove volatility and weak performance throughout the year:
· While the sell-off was initially sparked by market unease over the Fed winding down its purchases of U.S. Treasuries and mortgage-backed securities, it continued through the fourth quarter as markets grew anxious over the weakening global outlook.
· Fund flows remained volatile throughout the year. High-yield bond funds and bank loan funds recorded net outflows of $6.3 billion and $17.3 billion for the year, respectively.
· Leveraged credit new issue activity remained robust despite weaker demand, reaching $833 billion–the second highest volume on record. Mergers, acquisitions and leveraged buyout activity represented 40 percent of new issue volume, the highest share since 2008.
· The decline in oil prices during the second half had a material impact on high-yield bond spreads generally, as energy-related companies represented 16 percent of the high-yield corporate bond market.
Our call to start moving up in quality in our July 2014 report was well-timed given that risk aversion drove performance at the end of the year. CCC bond spreads widened the most, ending the year 324 basis points wider than mid-2014 levels, while BB and B bonds were 96 and 190 basis points wider, respectively. From a total return standpoint, CCC-rated corporate bonds underperformed BB and B-rated corporate bonds in the second half of the year by 465 basis points and 313 basis points, respectively and CCC-rated bank loans underperformed BB and B-rated loans over the same time period by 8 basis points and 74 basis points, respectively.
In an environment where U.S. economic growth has been strong and the S&P 500 has set new highs, the underperformance of more beta-sensitive CCC credits speaks to the multitude of risks that are emerging in the later stages of the credit cycle. Specifically, macro-level risks are playing a larger role in returns. The winners and losers in high yield in 2014, marked by total returns by individual sectors, highlights the overwhelming effect that factors such as oil and metals prices have had on certain sectors. In the next section, we share our views on one of the vulnerabilities—declining oil prices—which may continue to impact credit returns in 2015.
Beware of Macro Risks
The Role of Declining Oil Prices in High Yield
Falling oil prices as a result of oversupply and reduced demand are a significant concern in North America given that advances in extracting energy from shale rock over the past decade have made the U.S. a significant producer of oil and natural gas liquids. In November, the Organization of the Petroleum Exporting Countries (OPEC) decided to leave its production quota unchanged, resisting pressure to cut supply in 2015 as demand falls. This means that oil prices will have to find an equilibrium on their own in an already oversupplied market. In the past 25 years, we have seen Brent oil prices fall to as low as $10 per barrel, so it is not out of the realm of possibilities to see oil prices decline even further. We do not see a significant decline in new oil supply in the short run and prices could drop below $40 a barrel before supply begins to decline.
As the U.S. has made significant gains in energy independence, debt outstanding for energy-related companies has ballooned. Over the past 10 years, energy-related investment-grade and below investment-grade debt has grown by 371 percent and 276 percent, respectively, outpacing the growth of the whole investment-grade and high-yield markets. Today, energy represents 10 percent of the market value of the Barclays Investment-Grade Corporate Bond Index and 15 percent of the Credit Suisse High-Yield Index. In high yield, energy holds the second largest share behind media and telecom.
On the surface, the growth in energy should not be very concerning. Energy companies have been among the lowest-defaulting sectors since 1970, according to Moody’s data. The average annual default rate for energy-related corporate bonds is only 1.4 percent, compared to 2.9 percent average annual defaults in media & publishing and 2.0 percent for consumer industries, which includes beverage, food, tobacco, and other consumer-related sectors. However, we note that high-yield debt issuance has shifted from gas distribution toward the less stable exploration and production segment (E&P). This segment tends to be more capital intensive, relying heavily on debt and equity markets to fund development of shale resources. It is therefore also highly dependent on the price of oil to drive profitability of U.S. shale projects. While some shale formations remain profitable with oil below $50 a barrel, profitability was already questionable at $80 a barrel for others. Deutsche Bank’s credit strategists estimate that if West Texas Intermediate remains below $60 a barrel for a sustained period of time, it could push the energy sector into distress. We also note that with oil prices falling last year, a number of high-yield energy deals were postponed or were forced to offer higher coupons or additional covenants.
Given the sector’s increased sensitivity to oil prices and the growth in debt outstanding across the energy sector, it is not surprising that energy contributed the most to the high-yield sell-off in the second half of 2014. Between July and December, the Credit Suisse High-Yield Index fell by 3.4 percent while the energy component was especially punished with a loss of 15 percent. Credit spreads for energy high-yield bonds widened by 104 percent and ended the year at 819 basis points over Treasuries. In fact, energy high-yield spreads contributed to 31 percent of credit spread widening in the Credit Suisse High-Yield Index over the second half of the year.
Stress Testing for Worst-Case Scenarios
To say that investors should carefully examine energy exposures in their portfolios is an understatement. The most prudent course of action would be to stress portfolios for worst-case scenarios. When oil broke through $80 a barrel — a floor that it had not crossed in over four years — we stress-tested individual energy companies for an environment where oil falls to $45 a barrel and $25 a barrel. Today, energy bonds we own are tested under a scenario where oil does not rebound above $60 for the life of the bond. This is similar to an internal process called “Groundhog Day”, where collateralized loan obligations (CLO) are stress-tested under 1930s Depression-Era default levels before an investment is made. As expansions become extended, investors become complacent and fail to consider downside risk. The collapse in oil prices in 2014 hopefully serves as a reminder of the importance of prudent investing that incorporates an analysis of potential losses in a worst-case scenario.
After a careful analysis of energy exposures, what should remain is a well-diversified portfolio that includes integrated energy companies (those that have diversified sources of revenue across all aspects of the energy industry, including exploration, production, refinement and distribution) and select independent energy companies with strong fundamentals (those that only explore and produce oil and natural gas). To that effect, we highlight that high-yield bond spreads in exploration and production widened by 118 percent since June, while those in the midstream segment widened by 43 percent, demonstrating that energy companies with diversified sources of revenue are better positioned to withstand declining oil prices.
Leverage multiples and interest coverage gives us a sense of how long it would take to see defaults rise if a sector experienced severe distress. Energy’s fundamental strength compared to other sectors, as we see in the charts below, stands out in light of the volatility in 2014. This means that there is a fairly long runway until we see defaults rise in a dramatic fashion, so we don’t expect to see widespread defaults over the next year. We are using this as an opportunity to significantly cut energy exposures and position defensively in the sector.
The Value in Stable Cash Flows and Limited Cyclicality
Examining energy-related credits addresses the first-order effect of declining oil prices, but there may also be second-order effects to come. This refers to the contagion-like effect, where pressure in the energy industry may unexpectedly put pressure on other industries. Some examples include companies that provide the chemicals required for the fracking process and financial services companies that have enjoyed gains from significant energy-related new issue activity over the past several years. Ultimately, this process may help investors identify the Black Swan that could lead to significant losses in the market.
Black Swan events are difficult to identify, but a properly constructed credit portfolio that focuses on company quality beyond a credit rating can evade losses while capturing upside reward in a bull market. Guggenheim’s credit team carefully scrutinizes companies with heavy capital expenditure needs that can impair cash flow generation, which include energy, but can also include sectors such as media where intense competition forces companies to constantly reinvest in new technology to maintain market share and continue growing. Capital expenditures as a percentage of revenue in media in 2014 exceeded 15 percent. By comparison, the average share of capital expenditures to revenues for the broader high-yield market over the past 10 years is approximately 8 percent.
Beyond capital expenditures, we also consider cyclicality. Cyclicality is a trait that can yield great returns in a strong market, but becomes a weakness in a market that is concerned about global growth and the potential implications to U.S. companies. Among highly cyclical sectors are gaming and leisure, whose products are considered a discretionary expense and therefore are generally more sensitive to economic growth. While we don’t believe there is a risk of higher defaults in highly cyclical industries in the near term, a well-positioned portfolio should have limited exposure to this segment.
Given the variation of fundamental metrics within high yield, we tend to favor investments in companies with recurring revenue streams and high-quality margins, which we’re currently seeing in technology, consumer retail (which should also benefit from declining gas prices), and healthcare. Attachment point in the capital structure, which refers to the seniority of the bond and the exposure to loss in the event of a default, is also important. Our approach should allow us to filter out fundamentally weak credits, benefit from continued U.S. economic growth and remain well positioned to withstand darker days.
Important Notices and Disclosures
INDEX AND OTHER DEFINITIONS
The referenced indices are unmanaged and not available for direct investment. Index performance does not reflect transaction costs, fees or expenses.
The Credit Suisse Leveraged Loan Index tracks the investable market of the U.S. dollar denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or Ba1/ BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries.
The Credit Suisse High Yield Index is designed to mirror the investable universe of the $US-denominated high yield debt market.
The S&P 500 Index is a capitalization-weighted index of 500 stocks, actively traded in the U.S., designed to measure the performance of the broad economy, representing all major industries.
The Barclays Investment-Grade Corporate Bond Index covers USD-denominated, investment grade, and fixed-rate, taxable securities sold by industrial, utility, and financial issuers.
Spread is the difference in yield to a Treasury bond of comparable maturity.
A basis point (bps) is a unit of measure used to describe the percentage change in the value or rate of an instrument. One basis point is equivalent to 0.01%.
Discount margin to maturity (dmm) is the return earned at maturity that is over and above a specific reference rate associated with some type of floating rate security. Discount margin to maturity assumes three year average life. Spreads and discount margin to maturity figures shown throughout this piece are expressed in basis points.
Leveraged buyout activity refers to the acquisition of a company where a significant amount of debt, which may include bonds or loans, is used to finance the transaction.
Fixed-income investments are subject to credit, liquidity, interest rate and, depending on the instrument, counter-party risk. These risks may be increased to the extent fixed-income investments are concentrated in any one issuer, industry, region or country. The market value of fixed-income investments generally will fluctuate with, among other things, the financial condition of the obligors on the underlying debt obligations or, with respect to synthetic securities, of the obligors on or issuers of the reference obligations, general economic conditions, the condition of certain financial markets, political events, developments or trends in any particular industry and changes in prevailing interest rates. Investing in bank loans involves particular risks.
Bank loans may become nonperforming or impaired for a variety of reasons. Nonperforming or impaired loans may require substantial workout negotiations or restructuring that may entail, among other things, a substantial reduction in the interest rate and/or a substantial write down of the principal of the loan. In addition, certain bank loans are highly customized and, thus, may not be purchased or sold as easily as publicly-traded securities. Any secondary trading market also may be limited, and there can be no assurance that an adequate degree of liquidity will be maintained. The transferability of certain bank loans may be restricted. Risks associated with bank loans include the fact that prepayments may generally occur at any time without premium or penalty.
High-yield debt securities have greater credit and liquidity risk than investment grade obligations. High-yield debt securities are generally unsecured and may be subordinated to certain other obligations of the issuer thereof. The lower rating of high-yield debt securities and below investment grade loans reflects a greater possibility that adverse changes in the financial condition of an issuer or in general economic conditions, or both, may impair the ability of the issuer thereof to make payments of principal or interest. Securities rated below investment grade are commonly referred to as “junk bonds.” Risks of high-yield debt securities may include (among others): (i) limited liquidity and secondary market support, (ii) substantial market place volatility resulting from changes in prevailing interest rates, (iii) the possibility that earnings of the high-yield debt security issuer may be insufficient to meet its debt service, and (iv) the declining creditworthiness and potential for insolvency of the issuer of such high-yield debt securities during periods of rising interest rates and/ or economic downturn. An economic downturn or an increase in interest rates could severely disrupt the market for high-yield debt securities and adversely affect the value of outstanding high-yield debt securities and the ability of the issuers thereof to repay principal and interest. Issuers of high-yield debt securities may be highly leveraged and may not have available to them more traditional methods of financing.
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