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Will Energy Kill High-Yield? No!


Bears predicting a disaster in the high-yield bond market had better think again.

All weekend long, my Twitter stream has been lit up with claims that the junk bond market is on the edge of the precipice and that high-yield bonds of energy companies are doomed.

Since energy debt comprises some 16% of the high-yield market (I am not sure what bonds are factored into that percentage, or where it comes from, but I'll take it on faith), its collapse will tank everything, and in no time we will be back in a 2007-2008 style crash.

Let me offer some figures that put the energy problem into perspective:
  • Total US E&P Bonds Outstanding (High-Yield and Investment Grade)  = $197B;
  • US companies with at least $1B of bonds outstanding comprise approximately $161B of the $197B;
  • At Friday's close, approximately $35B of the $161B traded below 90c on the dollar;
  • Of the $35B approximately, $12B are considered distressed (i.e. the spread to Treasury is more than 1000bps), including $1.5B of a company that is already bankrupt, and $1.2B of a company that has been on life support for about a year.
  • And to further frame the size of the E&P credit problem, the junk market has issued approximately $344B of new bonds year-to-date.
One of the silliest tweets I read was the comparison of the HY E&P credit issues to the Worldcom fiasco.  At risk of putting facts in the way of a dumb theory, WCOM's $38B dollars of indebtedness went from investment grade to "D" (as in "defaulted") almost overnight during the 1st half of 2002 (Worldcom filed for protection in July of '02) when junk issuance totaled $21B. For all of 2002 it totaled $59B. And back in '02, Worldcom flat out overwhelmed the junk market. Today, if all the E&P debt currently trading below 90c were to default manana, it would comprise 10% of this year's new issuance.

E&P credit is absolutely a problem for E&P companies and the group overall (I've been tweeting and writing about this for months now), but that's that. Protestations that it will serve as the catalyst for a  widespread "black-swan" are, in my humble opinion, pretty close to complete nonsense.

Now I'll turn to the broader issue of junk spreads. Tons of tweeps are freaking out because HY spreads have risen about 125bps from the June post-crisis lows of approximately 325bps to 450bps. 

For all the reasons I explained here (subscription required), and in the context of the widening/tightening moves HY has seen since March of 2009, the recent spread increase is close to meaningless. In fact, if one considers that $186B of new junk bonds have been sold between June 1 and November 30, 2014, the widening seems entirely reasonable (Econ 101: when supply rises, prices tend to fall). 

However, since I have learned the hard way not to dismiss other people's views in Pavlovian fashion, and since the equity markets are giving off a whole lot of DeMark Sell/warning signals, I dusted off one of Rosenblatt's Brian Reynolds' more arcane indicators: the ratio of the earnings-yield of the S&P 500 (SPX) (the inverse of the P/E ratio) to the yield of junk bonds. The higher the ratio, the more "cheap" stocks are relative to junk bonds, and vice-versa. 

The chart below shows the SPX' EY-to-Junk Yld ratio, as well as the Total Return Index of the SPX and of the FINRA-Bloomberg Active HY US Corporate Bonds.

Click to enlarge

As you can see, going back to 2005, the ratio has been a pretty good tell of the near/intermediate term returns of both stocks and high yield bonds, and the current negative divergence between the ratio and equities is reminiscent of what preceded the scare in the summer of  2011.

If I have to give the bears a bone for all the arguments that so far have proven to be fodder for ever-rising stock prices, this particular valuation divergence is it. 

The drivers of the corporate bond market -- money flows, issuance, credit derivatives, leverage levels, etc. -- are all flashing green (E&P credit issues notwithstanding), and those factors overwhelmingly favor much higher prices for stocks over time.

But by the same token, relative to HY bonds, equities just may have gotten too far ahead of themselves and it is prudent to consider the possibility of another nasty swoon sooner than later.

Twitter: @FZucchi
No positions in stocks mentioned.
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