Monday, January 12, 2015

The Consequences of Overheating in the Energy Bond Market

Updated February 3, 2015

A speech by Jeremy Stein, former Governor of the Federal Reserve Bank of St. Louis looks positively prescient, particularly as interest rates appear to be heading up and the price of oil has fallen substantially.

In his speech, "Overheating in Credit Markets: Origins, Measurement and Policy Responses", Mr. Stein examines the factors that lead to "overheating" (think bubble formation) in credit markets and why there are credit booms and busts.

He notes that there are three factors that can contribute to "overheating" as follows:

1.) Financial innovation: While financial innovation has provided benefits to the economy, it can lead to the creation of new financial products that do not fall under any sort of regulation since the regulators tend to act well behind the changes in industry.  A prime example of this is the existence of second-generation securities like the subprime CDOs that came into existence during the housing boom.  As we all know, it was the collapse in the value of these imaginative new derivatives that nearly caused the world's economy to implode.  The financial industry is guilty of making decisions on their own behalf that maximize their profits and compensation and, in the competitive nature of Wall Street, these decisions are made solely to attract new money and increase the assets that are under management.

2.) Regulation: As new regulations are implemented, they tend to open new regulatory loopholes which spur the development of new products, once again, in an attempt to maximize profits and compensation.

3.) Change in Economic Conditions: I'm going to quote directly from Mr. Stein's speech for this one:

"The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to "reach for yield."  An insurance company that has offered guaranteed minimum rates of return on some of its products might find its solvency threatened by a long stretch of low rates and feel compelled to take on added risk.  A similar logic applies to a bank whose net interest margins are under pressure because low rates erode the profitability of its deposit-taking franchise. "

Hold your thoughts on that one for a moment.

Mr. Stein goes on to note that all three of these factors can interact with each other and gives the example of a low interest rate environment that increases the demand for the financial industry to engage in "below-the-radar forms of risk-taking".  He notes that the high demand for high-yield (i.e. junk bonds) is part of investors "reaching-for-yield" in this low interest rate environment, an issue that could result in significant losses to junk bond investors.

In Thomson Reuters latest Debt Capital Markets Review, they note that global high-yield corporate debt issuance fell over the last two quarters but was still just below the record of $442.5 billion set in 2013 at $441.5 billion as shown on this bar graph:

Nonetheless, as the graph shows, since 2009, the issuance of corporate junk bonds has mushroomed since the end of the Great Recession, particularly when we compare the total dollar value issued between 2009 and 2014 to the value issued in 2006 and 2007.  This is thanks to two factors:

1.) companies that are less creditworthy are able to raise funds at relatively low rates compared to the past because of the global low interest rate environment as shown on this graph:

You'll note that the drop off in junk bond issuance pretty much parallels the increase in interest rates from below 8 percent in June 2014 to the current rate of 11.46 percent.  You will also observe that the spread between junk bonds and Treasuries was at a multi-year low in mid-2014 as shown on this graph:

2.) investors are "reaching-for-yield" because of the prolonged period of near-zero interest rates on Treasuries and other fixed income investments.

Fortunately, for those of us that are non-professional investors, FINRA provides a bond market pricing and yield tool.  From their website, we can see what has happened to the price of high yield bonds over the past year (and I apologize for the quality of the screen capture in advance):

Now, let's put the recent collapse of the price of oil into this equation and see what has happened to the price and yield of some oil sector bonds, including a sample of bonds issued by smaller oil shale players, over the past year, noting that the current yield is well above the coupon interest rate:

1.) Rex Energy: 8.875 percent maturing December 1, 2020 - rated B-

a.) Price:

b.) Yield:

2.) Goodrich Petroleum: 5 percent maturing October 1, 2029 - rated CCC


Yield: currently trading at $52 resulting in a yield of 12.021 percent.

3.) Halcon: 9.75 percent maturing July 15, 2020 - rated CCC+



Switching gears for a minute, let's look at one world's largest oil well drilling companies:

4.) Transocean: 7.5 percent maturing April 15, 2031 - rated BBB-

a.) Price:

b.) Yield:

I think that's enough information to give you a general idea of the problem.  The debt of smaller oil companies exploiting shale oil reserves in North America and those that are viewed as weaker players is getting hammered.  Not only will it be difficult for these companies to raise money at these high interest rates, their low share prices will make it difficult to issue additional equity to fund their ongoing operations.

According to Citi Research, the energy sector accounts for 17.4 percent of the high-yield bond market, up from 12 percent in 2002.  Smaller oil companies involved in the high-cost high-decline fracking plays rely on debt to fund their operations, however, in this low price environment, it will be increasingly difficult for them to rely on cash flow to fund further operations because of low prices and high production decline rates and an inability to raise additional capital through the issuance of new debt unless they are willing to pay bondholders substantially higher interest rates.

When we combine what is currently happening in the world's oil market, the high-yield energy bond market and Mr. Stein's observations about "overheating in the credit market", it is apparent that the Federal Reserve's prolonged policy of near-zero interest rates is coming apart at the seams.  Unfortunately, as was the case in 2008 - 2009, it is the small retail investor that will pay the biggest price for the Fed's mistake.

No comments:

Post a Comment