Markets aren’t like Las Vegas. What happens in one market doesn’t stay there for long. The latest poster children for the ripple effect are energy markets and credit markets.
Recently, movements in the volatile oil futures market had a direct and immediate impact on the bond market. Here’s what happened, why, and how it affects your investments.
Markets moving in tandem. Light sweet crude oil’s recent low on Feb. 11 coincided with spikes in the cost of borrowing money for big businesses. West Texas Intermediate, the U.S. benchmark, hit $26 a barrel, according to data from Bloomberg. As recently as mid-2014, futures prices had traded around $100 before beginning to slide as output by crude oil producers overtook demand.
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Meanwhile, that same day, the difference between what the U.S. government pays to borrow money and the rate that corporations pay, known as the credit spread, hit highs not seen in more than four years.
The Bank of America Merrill Lynch U.S. Corporate BBB Option-Adjusted Spread, which measures how much the most credit-worthy firms pay to borrow, peaked at 3.03 percent on Feb. 11, according to data from the Federal Reserve Bank of St. Louis. The last time this spread was that high was January 2012.
Corporate bonds are typically divided into higher quality securities (termed investment grade) and high-yield securities, also known as junk bonds. And these less credit-worthy borrowers paid even more.
On Feb. 11, the BofA Merrill Lynch US High Yield Option-Adjusted Spread, which measures the additional cost for-junk rated borrowers versus the government, hit 8.87 percent. That was the widest spread since 2011.
The problem was that so many oil producers were in debt and the declining price of crude increased risks that the companies would not be able repay lenders. More risk resulted in higher interest rates.
Fallen angels is the name given to bonds that were once rated highly but have fallen to junk status. This status matters because some pension funds, insurance companies and money managers have restrictions on owning junk-rated debt securities.
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“The oil company bonds were rated as being investment grade, but were on the verge of being downgraded,” says Jeremy Hill, head of markets investment manager and broker dealer, Levy, Harkins & Co. in New York. “The worry was that they’d become fallen angels.”
On the rebound. Since February, the price of oil has rallied to about $47 a barrel. In tandem with recovery, the relative cost of borrowing for corporations has declined.
Bond traders saw a higher price of oil and quickly decided the earlier risks of lending to oil producers were lower. As a result, the price of corporate bonds was pushed up and the yields declined. Bond prices and yields move in opposite directions.
“There was almost instant visible relief in the debt markets,” says Stephen Guilfoyle, managing director NYSE Floor Operations at Deep Value Execution Services.
Systemic risk. There was also relief in the banking business.
“Their biggest concern was the loan book to the energy space,” says David Nelson, chief strategist at Belpointe Asset Management in Greenwich, Connecticut.
The credit market meltdown wasn’t limited to the bond market. Banks had made loans to the oil patch, in particular to drillers in what Nelson calls Shale-land, referring to the areas where oil is being extracted from shale formations using a technique called hydraulic fracturing, or fracking. “Now that oil is in the $40s, we don’t have that systemic risk,” Nelson says. “That’s good news for the financial community.”
The future? One economic maxim holds that the cure for low prices is low prices. As low prices cause the least efficient producers of a product, in this case oil, to curtail their production, supplies will decrease and eventually match demand.
Does this mean that the price of oil will skyrocket back to $100? Probably not this year.
“For every dollar oil goes up that’s a number of wells that start being profitable,” Nelson says, increasing supply and putting a potential cap on a big price rally.
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In the longer term, the plunge in oil prices since 2014 prompted companies to cut back their exploration and development spending. This could affect future supplies when demand for oil rebounds.
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How the Oil and Credit Markets Became Linked originally appeared on usnews.com
