Bond markets flashing red and an oil plunge could make things worse

The U.S. high-yield index has widened 115 basis points and investment grade 30 basis points over the last month, leading many to ask whether these credit bonds are the real canary in the coalmine for global markets.

One catalyst for the underperformance in the investment grade space has been the acceleration of rating downgrades at the upper end of the capital structure. According to Goldman Sachs analyst Lotfi Karoui: “$90 billion worth of bonds have migrated into ‘BBB’ territory (from A); this is the highest amount since the fourth quarter of 2015.” A triple-B bond is rated one notch above junk so investors get a high return to something that’s perceived to be quite a risky investment.

The risk is for further negative actions especially as, according to Deutsche Bank research, ‘BBB’ bonds constitute about 60 percent of the overall U.S. investment grade market.

A continual downgrade drift would exert pressure on lower parts of the capital structure and could eventually increase the size of the high-yield bond market — a cohort that has also been struggling this year as interest rates have gone up.

The high-yield market also continues to exhibit a higher risk factor to oil prices and that has had a big impact on that market. According to the Goldman Sachs report, almost a quarter of the gross issuance in these bond markets this year has been in energy-related industries (albeit a large chunk has gone into refinancing and debt repayments) and constitutes about 16 percent of the outstanding market.

As the price of oil has slumped 30 percent since October, downside risks for high yield have increased especially as the oil plunge in 2014 elicited a wave of defaults in the energy sector and subsequently in the high yield market. This time around though, the breakeven level for many of these high-yield shale companies appears to be about $20 lower than it was back in 2014 to 2016, at around $51 per barrel, according to Goldman analysts.

Any further drop in the oil price from here would be a worrying development — credit investors are hence also keeping a close eye on the OPEC meeting.