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

 

They are expecting energy related defaults to increase to 10%. However, excluding energy, they are expecting default rates to be 1.5%, about half of the historical average of 3.8%.

Just as we saw contagion from energy weakness translate to general high yield market aversion in Q4 2014, we are seeing the same again today.  However, just because there are apprehensions about the energy sector, it doesn’t mean the entire high yield market should be abandoned.  We believe that should there be a spike in defaults, they will largely be contained to the energy industry and see the fact that much of the rest of the market is currently being brought down along with it as an opportunity to purchase these non-energy companies at attractive prices.  We continue to caution investors that are exposed to the broad indexes/index-based products that have higher exposure to the energy sector and are not building portfolios based on fundamentals to do some work to better understand what they own.  However for active managers who focus on credit selection and fundamentals, we see the current environment as ripe for the picking.

1 The energy industry is 16.29% of the J.P. Morgan U.S. High-Yield Index.  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, July 24, 2015, p. 59.

2 Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 10, 2015, p. 4-5.

Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. Information on this website is for informational purposes only. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risk and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.

This article was written by Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD).