March 13, 2020

Impact of Oil Collapse on High Yield Bond Market

by Tajinder Dhillon.

Brent oil has entered into a bear market, as prices have fallen almost $30 a barrel since the beginning of the year. Initial worries over COVID-19 caused the largest weekly decline in Brent oil prices since January 2016, having declined 13.6% during the week of February 28.

The sell-off intensified when OPEC+ concluded its meeting on March 6 without a deal to further cut oil production. As a result, Brent oil suffered its largest one-day drop since 1991, declining 24.1% ($10.9/barrel).

Oil majors including Exxon, Chevon, BP, ENI, and Total have all seen downgrades to Q1 EPS estimates and are all expected to miss earnings when they report next quarter according to the StarMine Predicted Surprise. Of this group, Exxon currently has the largest negative predicted surprise at -18.0%.

Impact on high yield bond market

The impact of further declines in oil will be easily understood by the equity market. However, it is just as important to look at the impact on the bond market. Companies who default on debt obligations or face bankruptcy will directly impact the equity market.

The BAML U.S. High Yield Index looks at U.S. companies who issue high yield debt. The index contains over 900 companies and close to 2,000 bonds, providing a comprehensive view of the U.S. high yield market. An important question to ask is – how much of the index is exposed to the energy sector? The answer is 11.7%. For comparison, the energy sector has an approximate 2.8% weight within the S&P 500.

With such large differences in exposure, we can see the importance of oil prices on the bond market. Looking at the debt maturity profile of the U.S. high yield index, it will be vital to pay attention to the energy sector’s ability to service debt in the near term. Approximately $100.6 billion of face value energy debt is due within the next five years, as shown in Exhibit 1. This is equivalent to 58% of the total face value debt within the energy sector, which is $174.5 billion.

Exhibit 1: Energy Debt Maturity Schedule

Exhibit 2 highlights the bond rating profile of the high yield index, which is another indicator highlighting the vulnerability of the energy sector. Energy debt appears to be concentrated towards lower rated bonds, particularly in BB3, B1, CCC1, and CCC3 buckets. In total, 52.3% of energy debt has bonds in these rating categories compared to 37.2% of the overall index (excluding energy).

Exhibit 2: Bond Rating Profile for Energy Sector

Aggregate StarMine Credit Rating Scores

The aggregates app in Eikon by Refinitiv allows users to view aggregate data by business classification, geography, portfolio, or index in a fully customizable display enabling trend observation and relative asset allocation decisions.

Our Combined Credit Risk model is a multi-pronged approach to predicting credit risk that combines our three stand-alone credit models: SmartRatios Model, Structural Model and Text Mining model. The SmartRatios Model incorporates financial ratios including profitability, leverage, coverage, liquidity, growth and stability to assess a company’s credit condition and financial health.

When looking at micro and small-cap U.S. companies in Exhibit 3, the energy industry group has a SmartRatios Implied Rating of B+, which is below investment grade. It also has one of the lowest Combined Credit Rank scores among all industries with a region percentile score of 16. A prolonged negative oil price environment will likely prove damaging for small exploration & production companies who are highly leveraged and operating in a capital-intensive business. Further pressure on oil companies will persist if bonds ratings are downgraded by credit rating agencies.

With a challenging outlook, analysts have been downgrading micro and small-cap energy companies, resulting in an aggregate Analyst Revisions Model (ARM) score of 35. Energy companies also appear out of favor with institutional investors as indicated by the SmartHoldings Model, scoring a percentile rank of 24.

To access the aggregates app in Eikon by Refinitiv, type “AGGR” in the search toolbar.

Exhibit 3: StarMine Aggregates Ranking for U.S. Energy Industry Group

Source: Eikon by Refinitiv.

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