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.