Despite coming off a year with a relatively low number of defaults, weakness in the commodity sectors, particularly in energy and mining, is likely to lead to more defaults in the high-yield market in 2016.
Last year’s total defaults represented about 2 percent of the market, while Standard & Poor’s estimates the long-term average is 4.4 percent. This year, however, the severe loss in the energy and mining sector could push the total percentage of high-yield bond defaults to 5 or 6 percent of the overall market, says Scott Roberts, co-head of high-yield investments and senior portfolio manager at Invesco in Atlanta.
Mariel Clemenson, managing director at Andres Capital Management in West Orange, New Jersey, says energy and mining represent 15 percent of the high-yield speculative bonds and loans.
More pain may come. High-yield investors need to be alert that this spate of defaults could start coming this spring, Clemenson says, as banks that loaned money to energy and mining companies are likely to cut credit lines.
“Typically, companies have several months to restructure, but there are so many companies whose credit lines are likely to be cut by an average of 30 percent [according to S&P] that the restructuring process may be akin to the proverbial camel passing through the eye of a needle,” Clemenson says. “These companies will either default or file for bankruptcy.”
The problem for energy companies in particular is crude oil prices have held in the low- to mid-$30-a-barrel area much longer than anyone expected. The extended price weakness also goes for miners of industrial metals, such as copper or aluminum.
“For energy and mining, prices have been low enough for long enough that you’ve seen restructurings that haven’t paid off and asset sales that haven’t worked out,” says Rob Haworth, senior investment strategist at U.S. Bank Wealth Management in Seattle.
Investors in high-yield bonds should take the time to look at their holdings, and if they are concerned, seek bonds or funds that focus on more stable sectors, such as consumer-oriented issues, the analysts say. Additionally, equity investors in some of these industrial commodity firms should review the bonds of the companies they hold.
“Here’s the dilemma for an equity holder in distressed company: The bond holders get paid back first if there is a default. The signal the markets are sending with these bonds trading 25 cents on the dollar [is] they are not worth par. There’s [generally] nothing left over for the equity holders,” Roberts says.
The energy firms most likely to feel the pinch are the independent, smaller exploration and production companies that look for new sources of oil and gas, along with the oil-field services segment, which installs equipment like drilling rigs, Roberts says.
On the mining side, industrial metal miners are more likely to default than gold miners because demand for building material remains weak, he says, while gold demand is firmer.
What bonds to consider. Clemenson says for investors who still want income from high yield but less risk, it may reside in what she calls “the crossover area.” Those bonds are rated lower-quality triple-B and higher-quality double-Bs, with a mix of the lower tier of investment-grade ratings and the higher tier of high-yield ratings.
But investors can’t buy blindly. “You have to select credit by credit in this very dangerous environment. How are the cash reserves? Do they have the support of their creditors? Some companies can renegotiate and get lifelines thrown to them,” she says.
Roberts says less risk-tolerant investors could look toward the consumer sector.
“We think the consumer is in good shape. We’re looking at areas where we have a strong consumer — in the retail space, automotive is strong, homebuilding stats are strong,” he says.
Haworth says he thinks the problems in the commodity high-yield sector are closer to the end than the beginning. However, because of the possibility of a further shakeout, he wouldn’t advocate buying a broad-based high-yield mutual fund or exchange-traded fund yet.
“I think it’s much too early to try and own the whole space. Yields are attractive — you can’t argue with that. But the pain from defaults across the broader index will be fairly high, and it may be tough for an investor to stick with that investment to where it will pay off,” he says.
Despite the concerns that default rates could rise and have a ripple effect in the rest of the high-yield market, David Kelland, bond market analyst at Chicago-based Briefing.com, takes a different view. There is some talk in the high-yield market about less liquidity, which may worry some ETF investors that they’ll have a hard time selling if conditions get worse, but Kelland doesn’t share that view.
“It might be a problem for mutual funds, but for the retail investor, [the lack of liquidity] doesn’t concern me too much. If people need the liquidity, it will be there. I think most of the damage in energy is done, and it’s not going to be a bigger problem going forward,” he says.
For investors who need income, Kelland says the yields on the two biggest ETFs, SPDR Barclays High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), beat the yield on the 10-year U.S. Treasury note by a wide margin. The SPDR ETF yield is 6.74 percent and the iShares ETF yield is 6.05 percent, versus about 1.85 percent for the 10-year note.
And those are the best funds to stick with, he says.
“I think it’s OK to stay with a broad-based ETF. They have the most liquidity. I’m not saying there won’t be problems later this year, but relative to Treasury yields, it’s a smart move,” Kelland says.
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Oil, Metals Weakness May Mean More High-Yield Bond Defaults originally appeared on usnews.com
