At the start of this year, credit investors undertook a conscious uncoupling from oil prices. As the cost of a barrel of West Texas Intermediate leaped in the wake of the production cut agreement announced by OPEC in November, a measure of junk-rated bonds lagged behind.
At the time, it looked like bonds sold by companies with more fragile balance sheets may finally have broken their ties to oil — a link that had helped roil markets from late 2015. But since then, correlation between crude and the iShares iBoxx $ High Yield Corporate Bond ETF has surged back to 72 percent. That isn’t far from a high of 86 percent reached a little over a year ago, when a dramatic dip in oil spread turmoil through credit markets.
The volatile relationship between high-yield bonds and oil prices has captured the attention of analysts and investors who are scratching their heads to understand debt investors’ conscious recoupling with commodities. While few expect correlation between crude and credit to return to negative levels, some do think the recent resurgence may be overblown.
“The U.S. high-yield market’s sensitivity to oil has increased noticeably in recent weeks,” wrote Deutsche Bank AG analysts led by Dominic Konstam. “Such a degree of sensitivity is an aberration and will probably fade away over time.”
The Deutsche Bank analysts reckon correlation will be closer to 20 percent to 30 percent in the future, helped along by sweeping changes in the U.S. energy industry. A shakeout in shale drillers and a desperate cost-cutting drive by the industry means remaining energy companies should be able to weather lower oil prices with a smaller risk of default.
“A change in the quality of U.S. energy sector composition is perhaps the most important reason to expect lower sensitivity going forward,” the Deutsche strategists said. “U.S. producers have become much more efficient in the last two years and many of them can now operate profitably with $50 oil. A recent increase in U.S. energy capital expenditure, drilling rigs, production, and inventories are a testament to this new-found resilience.”
In the meantime, there’s a bigger discussion brewing. Bonds issued by junk-rated energy companies have outperformed the broader high-yield debt market over the past six months, even as the price of oil rose less than $2 a barrel in that span.
“If sensitivity of overall high yield to oil was expected to stay this high for foreseeable future, the outperformance in energy high yield would be inconceivable,” the Deutsche Bank analysts concluded. “With this reasoning in mind, we continue to believe that recent spike in high-yield correlation to oil will be proven temporary.”