So You Want To Be An Oil Contrarian?

Now look, I don’t want to be an asshole, but if you were in HY last week and watched in horror as correlations between your junk and oil spiked furiously as crude collapsed…

…and then looked on in disbelief as everyone’s favorite pedestrian HY vehicles sold off…

…and spreads suddenly reversed 12 months of unrelenting compression…

… then you would certainly think that once things finally calmed down in crude like they did this week following the surprise EIA build…

…you’d be content to take it easy on the HY bullish bets for a while. Sh*t, you might even think about selling (gasp).

But not BofAML.

No sir.

They think it’s about time to get back in the saddle. Here’s an amusing bit out earlier this morning.

Via BofAML

Why

Oil started to recover after a 10% drop that became the focus of many market participants recently, pressuring both EM and corporate bond spreads. Our commodities research team expects a fundamentally driven recovery in oil prices. We look at the assets in our sovereign credit market that could benefit from rising oil prices, aside from the obvious Venezuela. Our HY research team thinks that the underweight by HY investors could be supportive, given the limited alternatives for finding high yielding assets.

Oil: fundamentals should help oil prices to recover

Oil tumbled last week as record US crude inventories clashed with record noncommercial oil net length of 557k contracts. This is the first correction since crude Brent had been trading in the $53-58 range after the November 2016 OPEC agreement to cut production. Despite concerns that have recently emerged about a potential supply glut in oil markets, fundamentals should help oil prices to recover. As our commodity team points out in Oil faces moment of truth, the reduction in global oil production and OECD oil stocks is not uniform; it has only started and is likely to accelerate, which ultimately would create upside pressure on prices as global supply diminishes, while global demand rises. Our analysts forecast Brent prices to reach $70 by the end of the second quarter and should average $61 over the year.

The better beta bang for your buck: HY vs EM

We analyzed the exposure of various sovereigns and sensitivity of the overall EM and HY markets to a change in oil prices and found that the US HY bond spreads are actually the most sensitive to changes in oil prices. EM sovereign and EM Corporate bond spreads follow, but with a lower beta. We estimate that a 10% increase in oil prices (around $5) would make the OAS spread of the BofA Merrill Lynch US HY Index drop by about 24bp (6%) and the BofA EM Sovereign index, EMGB, by 11bp (4%). Should oil rally $10, less than our commodity analyst forecast, from the current $52 to $62 by the end of 2Q (up 19%), the HY spread could decrease 48bp.

US HY investors have reduced their HY exposures to underweight, but they report that they also continue to reduce their EM corporate bond exposure, according to our investor survey. Our HY research team thinks that the underweight could cause spread compression, because investors may find it difficult to find alternative high yielding assets.