Background: The price of oil is currently at $54.73/bbl for WTI and $59.45/bbl for Brent. The street is currently contemplating if this could be a turnaround point for the commodity or, if oil still has more room to fall. While the short term price of oil is quite hard to predict, some clarity emerges in the medium and long term outlook. The current market outlook is that WTI will be at ~$61/bbl next year. This climate has implications for high yield companies in particular and that is what I will focus on today. The street expects the high yield market to continue grow next year and shorts on the ETF HYG are only 6% of current shares outstanding, compared to nearly 20% shorts earlier this year.
High Yield Companies: The High Yield Bond & Equity market has rebounded following Yellen’s “patience” statement but, I think this is only temporary reprieve. The single most important factor for high yield debt is if the company can generate enough cash flow to make its debt payments. The issue in my eyes is threefold: 1. Global oil price declines (and even possible recovery) won’t be enough to save high yield companies due to slim margins and overleveraging 2. The secondary effects (deflation concerns, stronger USD) of the oil decline will cause troubles for global high yield debt and 3. An interest rate increase by the Fed will limit refinancing opportunities that were bread and butter for high yield companies.
- Global Oil Price Decline: To begin, I decided to backtest the regression to predict HYG given 1 Mo. WTI Futures. The line resulted in an R-Squared value of only .18, which is practically meaningless. However, looking more closely at the data, we can see that declines in the price of 1 Mo. WTI Futures have a much greater correlation with falling HYG prices than positive price movements of the 1 Mo. WTI Future. Plotting this we find that negative price movements of 1 Mo. WTI Futures have a high correlation with falling HYG price while positive price movements have no correlation between positive HYG prices. While falling oil prices cause High Yield Bonds to fall, the reverse effect is not true. Thus, even if oil does rebound, there may not be a similar recovery in the market.
Qualitatively, this phenomenon can be described through high yield companies’ need for high cash flows to pay off their debt payments. Additionally, in the current low rate climate, the energy industry has capitalized on cheap financing through debt (most reaching debt to equity ratios of over 1.0), reflected in the sharp increase of their composition of the high yield market. Thus, when the price of oil drops, approaching the break-even points, the market panics due to need for the company to pay its debt obligations while when it increases, it doesn’t matter as much because obligations will be paid either way.
Looking more specifically at break-even points, data from Bloomberg after surveying a variety of US Shale producers yielded the chart in the appendix. The average price is at ~ $80/bbl but, due to several outliers, I would peg the price closer to $70/bbl. Many of these projects will be slashed going forward, reducing the cash flows. Additionally, the short term price of oil is much lower than the average break-even and incredibly volatile, leaving possibility for even lower oil prices. While a rebound is expected, it won’t be quick enough or great enough to keep these companies afloat. As debt payments become harder and harder to make, there will be shut-downs and defaults.
- Secondary Effects of Oil Price Decline: The falling price of oil is also contributing to global deflationary concerns and a rising US Dollar. Both of these secondary effects will also have serious consequences for high yield debt.
Falling oil/commodity prices are typically a signal of industrial slowdown and deflation. The “advanced” economies of Europe and Japan, where, despite central bank intervention, continue to stall due to ineffective government policies, outsourcing and cheap labor abroad, high youth unemployment, and growing government deficits to support an aging population. The consumer tax implemented by the Japanese government continues to contribute to falling GDP and lower consumer spending despite the massive amount of stimulus the BOJ is undertaking. CPI across the Eurozone continues to fall as previous periphery weakness makes its way to the core. Meanwhile, slowing Chinese growth continues to dampen commodity prices, causing havoc upon the various “commodity countries” across the globe like Canada, Russia and Australia. As consumers across these regions spend less, companies will make less nominal revenue, causing high yield debt to face their large payments without their previously large of revenue streams.
The US Dollar is currently thriving in this environment as lower oil prices drive the dollar higher. The US, despite recent changes, is still a net energy importer and therefore, as commodity prices continue to fall, the US Dollar will continue to rise. This puts massive pressure on international borrowers who have taken advantage of previously low US rates in order to finance their projects. As EM currencies devalue in relation to the dollar, high yield and companies that required large capex spending in Latin America will particularly be hard hit as a large chunk of the funding came through the US.
- Interest Rate Hike: The market is currently not fully recognizing the possible effects of a rate hike. Many companies simply say they are ready for a rate hike in future financing projects and current projects but, may be overlooking floaters. Most of recent projects in the energy industry have been issued through floaters in order to compensate for the low rate climate. In combination with falling cash flows, the debt payments could rise out of control over the next few years.
On top of this, 55% of this year’s high yield debt issuances have been through refinancing. The strategy had been to take advantage of low rates now but, the unfortunate side effect of this is that term structures become concentrated and it is not a sustainable strategy. As debt becomes tighter and more expensive with a fed rate hike, this could prove disastrous for companies when refinancing can no longer become an option.
Finally, I think we are entering a new climate of increased volatility in this market, due to underlying oil price fluctuations and the end of asset backed purchases, which diminishes the return to be gained on risk and making high yield debt a less viable investment.
Risks: The price of oil, being as volatile as it is, may swing upward dramatically, helping some of these companies survive. However, I think that is only a short term movement and as the price stabilizes, we can accept the companies to still be below their break-evens. Either way, these companies will face reduced cash flows which will affect their valuation in due time.
Additionally, continued disinflation could cause the fed to postpone a rate increase which poses as some relief to high yield debt. However, I still think the other combined effects will push high yield debt companies to their breaking point.
All this being said, I think that certain companies like AWLCF, which have contracted revenues have the ability to survive this climate because of strong cash flows and low debt to equity ratios. Thus, while I think the general market of high yield debt is going to take a hit, I think that is the perfect time to find companies with strong cash flows to invest in as they will prove to be viable value investments.
Conclusion: The high yield market is due to turn lower in 2015, due to the reasons above. We will probably see lower amounts of issuances and yields rise.