Earlier we noted that the plunge in oil prices and concurrent widening in HY energy spreads is one the week’s most important stories.
And not necessarily because HY energy is blowing out as crude crashes – that’s intuitive (although you’ll note that energy credit has, up until the past week or two, held up pretty goddamn well during periods where oil’s looked wobbly this year).
Rather, the reason this story is getting so much attention seems to be the relative resilience of HY as a whole in the face of widening in HY energy. In short, the “oil spill” isn’t “spilling” over. Here’s a great way to visual how concentrated the pain has been:
We also noted earlier today in “This Is The ‘Most Vulnerable’ Index In Credit To Macro Risk,” that CDX HY is perhaps the most challenged credit benchmark thanks to its exposure to both the oil story and the retail story.
Well unsurprisingly, this is the subject of the latest note from Deutsche Bank’s Oleg Melentyev, appropriately entitled “HY Energy Gives Back Six Months Of Tightening.” Below, find Melentyev’s take on where we are now and where we would need to get to before things start to turn ugly…
Via Deutsche Bank
HY energy bonds have come under a significant pressure over the past two weeks. Spreads in this sector have widened by 55bps during this interval, adding to their previous widening of 50bps since early-May (Figure 1). The weakness in energy names is also showing early signs of spilling over into ex-energy, where spreads currently stand at 370bps, or 5bps above their levels two weeks ago. Within ex-energy HY, a dominant share of weakness was attributable to retail, where spreads have jumped by 35bps in two weeks. The HY index ex-energy and exretail is unchanged over the past two weeks and currently stands at 355bps. In IG, the broad index is 1bps tighter over the past two weeks, with its ex-energy component 2bps tighter. Markit leveraged loan index is down 30bps in excess return terms over the past two weeks, even though its energy exposure is limited.
With oil and energy HY again becoming very topical here, we have updated our models to reflect latest market moves. Their current results still support the view we maintained for some time, which is oil weakness to this point is problematic directly to energy valuations but is not yet a cause for credit loss concerns in energy or broader HY market.
Having said that, we must acknowledge that things continue to move fast in this space, and we are getting closer to the point where this narrative could begin to change. While energy HY spreads have already repriced by +105bps, matching our expectations from early May, oil is down another 6.5% since then. At $43 oil, our model shows fair value energy HY spreads about 50-75bps wider from here (Figure 2). Every further $1 move lower in oil should produce 10bps in energy HY spread widening on top of the stated move to fair value.
How much lower can oil go before it becomes problematic to broader HY market? To answer this question, we updated a model from late 2014 we used back then to estimate the breaking point between WTI and potential pickup in credit losses. For that purpose, we build a scatter plot in Figure 3, where we relate oil price (horizontal axis) to HY Energy Debt/Enterprise Values (vertical axis). This relationship shows that D/EV is expected to stay inside 50% with oil over $40, and it could reach 55% at $35 oil. Historical evidence suggests that D/EV ratios at 60% or higher lead to a material jump in expected credit losses.
We believe that if energy D/EV ratios stay inside of 55%, the market would remain comfortable treating this episode mostly as a valuation issue in the energy space. Higher D/EVs could result in more sustainable repricing in risk premiums under the weight of recalibrated credit loss expectations and potential spillover into broader HY market through the fund flow channel. For the time being, we recommend a continued underweight in energy HY with target spreads of 575-600bps (+50-75bps from here). We would become mindful of implications for the broader HY market if oil were to drop under $40, and particularly if it were to head towards $35.