Oil has once again broken the $40 level, and then swiftly broke $35.  This recent leg down in oil has taken a toll on the high yield market given that the energy sector accounts for 13-16% of the high yield market, depending on the index you look at.¹  This means that funds that track these indexes would likely have a similar allocation.  While general default rates in the high yield market are expected to remain below their long term averages, this will not be the case for the energy and mining industries.

One of the top three ratings agencies recently gave their outlook on US high yield bond defaults, projecting energy related defaults to total 11% in 2016, while the non-energy and non-metals/mining sectors will face historically low default rates of 1.5%.  Similarly, J.P. Morgan is projecting a 10% default rate in energy and a 1.5% default rate excluding energy and metals/mining, well below the long term averages of 3.6%.²

We expect many energy companies, especially shale related producers, will not be able to make it through this cycle of low prices.  Many shale producers were not generating cash even when oil was more than double what it is today.  Additionally, these shale wells have massive decline curves of approximately 70% in their first year, meaning they require a large amount of capital to keep production flat, often resulting in a large cash bleed.  The high yield market is littered with these types of producers and also related service companies, thus we do expect oil and gas prices at these levels will certainly cause a spike in defaults related to the sector over the next year.  We are already seeing it happen with over 50% of defaults and distressed exchanges so far this year related to energy³, and as the hedges wear off in 2016 and the full effect of current oil prices are felt, we expect this energy related default activity to heat up.

Also related to energy, we see MLPs (master limited partnerships), which were high fliers and popular investment strategies not too long ago, as extremely vulnerable.   We had warned in the past for investors to be weary of return of capital versus return on capital.  The problem has been that these partnerships were providing a return of capital and now that access to capital (debt and equity) to continue to fund capital expenditures for growth and the dividend is drying up, resulting in dividend cuts.  We’ve recently seen some high profile companies cut their dividends, which is calling into question, rightfully so, the sustainability of dividends across the space.  There is likely more pain to come for MLP investors as the current lows on oil prices work through.

After it became apparent to us in early 2015 that lower oil prices were likely here to stay for the near-term, we significantly reduced our exposure to the energy space, maintaining an underweight to the sector relative to the various high yield indexes.  While we are intentionally underweight, we don’t believe the entire sector should be abandoned.  Certainly extreme caution and thorough understanding of the business fundamentals (including hedging activity, capital needs and cash flow generation/use) is warranted, but there are still a few selective opportunities we see in the space.  For instance, we are invested in a few exploration and production companies.  These are primarily Canadian-based conventional (not shale-related) producers in what we believe to be attractive geographies that get a margin benefit from incurring costs in a declining Canadian dollar and selling product in an appreciating U.S. dollar.  We focus on producers that have hedges in place for a portion of the production in 2016, minimal cash bleed after necessary capital expenditures and interest costs, relatively low leverage, ample liquidity, and that we believe can survive a prolonged downturn in prices, even if hedges roll off in 2016 and these low price points persist.

The concern about energy in the high yield market is appropriate for the index and products that track them as this is a large component of the indexes and, as noted above, there are a lot of energy related companies at risk as defaults increase in the sector, just as there are MLPs that investors should be weary of.  We expect there will be further losses and income disruptions.  But as an active manager, we have the flexibility to choose where we see value and believe there is compelling value to be had in many other sectors in today’s high yield market.  We are underweight the energy industry relative to the market, and the vast majority of our portfolio is diversely allocated to industries not related to energy.  As default rates in the non-energy sectors are expected to remain well below average, we believe we are positioned well and offering what we believe to be attractive, sustainable yield to investors.

1 For instance, energy is 14% of the J.P. Morgan 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, December 11, 2015, p. 39.

2  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High Yields Bond and Leveraged Loan Outlook,” J.P. Morgan North American High Yield Research,  December 9, 2015, p. 4.

3 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American High Yield Research,  December 1, 2015, p. 1.