With the energy markets once again taking a turn downward, we are seeing concern for the high yield market again escalating and talk of a spike in default rates heating up.  Yes, the energy industry does make up a large portion of the high yield market, in fact the largest industry holding within the space at about 14-17% depending on the index used.1 We do expect defaults to increase in this industry.  We have been very vocal in expressing our concerns and questioning the viability of many of the domestic shale producers and the companies that service them.

Given our expectation for continued volatility in the energy industry and expectation that it may well take the better part of this year until we see a more sustained recovery in this market, we did make the decision to significantly cut our own energy exposure earlier this year and are underweight relative to the broader market indexes.  However, we did maintain some investments in the space, as we do believe in the longer-term improvement in oil and see value in certain companies at current levels (see our piece “Mid-Year Update” for further detail).  The problem is that for many others, this improvement may not be quick enough for them to sustain their capital structures.  For instance, hedges put in place at much higher prices in prior years are now starting to come off, meaning that companies will now start to face the full impact of the current oil price reality.  Additionally, we’d expect both pricing and volume pressure for oil services companies as the year progresses.

We do expect default rates to increase in the energy sector but expect them to remain moderate for the rest of the high yield market, continuing to trend well below average despite spread levels around historical averages.  During the second quarter, J.P. Morgan released the following detail on their default forecast, and we wouldn’t disagree:2