Warning sign flashes in US junk market

Rising oil prices spell trouble for some risky credits

NEW YORK: Energy companies with junk credit ratings are thriving amid soaring oil prices, but good news for one of the high-yield space’s biggest segments looks like terrible news for the rest of the asset class.

Up until now, money mangers have viewed US high-yield debt as somewhat insulated from Russia’s invasion of Ukraine and the toll it’s taken on global markets. But should inflation, say from rising oil prices, get out of hand, that could spell trouble for some of the riskiest credits.

Put simply: The rally in high-yield energy may be happening at the expense of the rest of the market.

“If we end up with sustained elevated oil prices against a relatively static policy agenda at home, you risk a stagflationary outcome which could be a crusher for corporate profits,” said Noel Hebert, Bloomberg Intelligence director of credit research.

Returns for junk-rated energy companies have marched higher since Russia’s attack pushed oil up. The same can’t be said for the rest of high yield, which is quickly losing ground to energy on a year-to-date total return basis after they mostly moved in lockstep earlier in the year.

Over the past month, high-yield energy debt is the only sector that has posted positive returns for investors.

Transocean Ltd and PBF Energy Inc both have bonds that’ve returned more than 10% since Feb 24, when the Ukraine invasion began.

Meanwhile, bonds tied to Delta Air Lines Inc and American Airlines Group Inc tumbled this week as rising oil prices stoked concern over higher jet-fuel costs.

There are other concerning signs – besides rising oil prices – looming over Wall Street.

Consumer prices in February rose another 0.8%, to a 40-year high, driven by rising costs for food, energy and shelter.

Treasuries, the world’s biggest bond market, are flashing signals that the risk of a US recession is increasing as the Federal Reserve prepares to raise interest rates.

Russia is also a major supplier of essential nutrients for crops, prompting concerns of soaring food prices.

“If the economic fallout for the United States proves to be modest and the US Federal Reserve (Fed) proceeds with caution, it could be a supportive outcome for credit,” Morgan Stanley analysts led by Srikanth Sankaran wrote in note Monday.

“But the risks of a more adverse stagflationary outcome have also increased,” they wrote, adding that fundamental risks have also “increased significantly.”

CCC-rated debt, one of the riskiest segments of the US corporate bond market, is more sensitive to changes in the economic backdrop rather than fluctuations in interest rates; performance largely depends on a company’s financial health.

Risk premiums for the debt widened to the highest level since December 2020 this week.

“Energy prices, rising inflation and a tightening Fed are a lot for an economy to absorb, and they are the most economically sensitive,” said Scott Kimball, managing director at Loop Capital Asset Management, referring to CCC bonds.

“I think there’s better entry points ahead.”

While energy makes up about 13% of the junk-bond market, it only accounts for 5.4% of CCCs, according to Hebert. That is a significant drop from 13% at the end of 2019 before the pandemic swept across the globe. Energy is now more concentrated in the higher-quality BB space, leaving little room to help boost the junkiest band of junk debt.

To be sure, the labour market is strong and a recent report by UBS Group AG also suggests that US high-yield debt is well positioned to ride out volatility caused by Russia’s invasion of Ukraine. — Bloomberg