Outlook 2016: Junk will try to rebound, but energy, commodities weakness overhangs market

By Paul Deckelman

New York, Dec. 31 – There is a well-known old saying, “the third time is the charm,” roughly meaning that if you’ve tried to do something twice and failed, you may have better luck the third time around.

However, there is an equally venerable and well-known superstition that bad luck comes in threes – and the recent behavior of the high-yield market would seem to be an example of that.

For a third consecutive year, the junk bond market began the new year on a positive note in 2015, and proceeded to build up some momentum over the first several months of the year.

But then, just as had been the case in 2013 and again 2014, that early strength proved to be a misleading mirage and ultimately faded away.

Traders, analysts and other market experts queried late in the year by Prospect News suggested that 2016 is likely to be a crapshoot, with many of the same negative dynamics that impacted the junk world in 2015 – notably the continued weak prices for energy and other commodities that badly hurt the bonds of companies involved in their production, as well as the coming of higher interest rates – likely to remain in play during the upcoming year.

But some also said that this could create opportunities for profitable investments.

Third time unlucky

Back in 2013, strong liquidity-fueled market momentum seen through the first five months of the year evaporated in late May and early June, amid investor fears that after several years of easy liquidity due to the Federal Reserve’s quantitative easing monetary policies, the Fed would finally begin tapering off its monthly bond-buying program.

That program had supplied generous amounts of capital to the financial markets as they continued to recover from the lingering effects of the Great Recession that had begun shaking the financial world with the subprime lending crisis in 2007 and had continued with a vengeance through 2008 and on into 2009.

The widely followed Merrill Lynch High Yield Master II index, coming off 2012’s unexpectedly strong return for the year of 15.583%, more than three times its 4.383% 2011 close, was on pace to do even better than that. The index initially jumped out to a nearly 6% year-to-date return by early May of 2013 – only to surrender nearly all of those preliminary gains by late June on Fed fears, hovering just above breakeven for a while before getting its second wind and finishing the year returning 7.419% – respectable, but in view of the strong start, a little disappointing.

In 2014, when the long-dreaded tapering-off finally did begin in January after months of rampant speculation, investor fears that the U.S. economy would suddenly grind to a halt because of a little less liquidity being applied proved to have been overblown and unfounded.

As the Fed gradually weaned the economy off its liquidity injections by reducing them, month-by month, a pleasantly surprised Junkbondland began building up a good head of steam – only to be sabotaged, starting around the middle of the year, as energy prices began to come down, first gently and almost imperceptibly, but in something resembling a freefall by the year’s end.

In terms of the junk market’s return, it was, as the late baseball great Yogi Berra famously intoned, a case of déjà vu all over again.

Riding the momentum generated at the end of 2013 and fueled by ample investor liquidity, the index came roaring out of the gate just as before, again generating a nearly 6% year-to-date return by late spring before starting to weaken, around the same time that oil prices were just starting to come down from their peak levels of over $100 per barrel.

The index fell a little after that and had crept back up to its peak level for the year by early September, but things were all downhill after that as oil prices collapsed late in the year on the failure of OPEC to step in and cut production to lessen the supply glut; by mid-December, the junk index had actually slipped into the red for the first time since the fall of 2011, although it finally finished the year having returned 2.503%.

That pattern – a strong start that ultimately could not sustain its momentum – continued into 2015.

But unlike those prior years – which each saw upturns later in the year to gain back at least some of their lost ground – 2015 saw similar efforts to regain the momentum fail and the year was on track to see junk’s first actual yearly loss since 2008, during the depths of the financial crisis.

The Merrill Lynch index once again started strong in 2015, reaching its peak level of 4.062% on May 29 before starting to come down from there and finally sliding into the red on Aug. 20 and staying in negative territory for most of the next two months.

Short-lived rally attempts in September and again in late October going through early November went nowhere, with the index turning south for good on Nov. 16. By Dec. 14, with the year’s end less than three weeks away, the year-to-date loss had ballooned out to 5.957% – its worst level since the end of 2008, when that year’s loss had clocked in at more than 30%.

What went wrong?

As 2015 began, investors – even though they were aware of the grim reality that the good times were over in energy and knowing that somewhere down the line, interest rates were bound to inevitably start rising again – continued to pour money into the junk bond market, with net inflows of fresh cash into junk-rated mutual funds and exchange-rated funds, considered a reliable barometer of overall liquidity trends, recovering from early weakness to reach a peak level of some $11.476 billion during the week ended April 15, after which the inflows started to trail off, eventually falling deeply in the red later on in the year.

“I think the reason we saw the inflows was everyone was still starving for yield, still starving for a return,” said Mathew Van Alstyne, the co-founder and managing partner in charge of research at New York boutique broker-dealer Odeon Capital Group LLC.

“I don’t think anyone was going in with their eyes closed to the fact that interest rates could rise and the junk bond market could get really hurt,” he said, pointing to the severe slide in junk bonds during the year’s final month.

“But the whole idea was to try and get out before your friends got out – you don’t have to out-run the bear, you just have to out-run your friend.”

He noted that as the year began, the junk market “was already tight, on a spread basis (versus Treasuries) – and got tighter. The Merrill Lynch index’s 2014 close at a spread to worst of 513 bps tightened to 451 bps by early March, its tightest level of the year.

“Mathematically, how close was it ever going to get on spreads to Treasuries?” Van Alstyne asked rhetorically.

He continued that “obviously mathematically, you can get to a point where it is as completely tight as it can be, but – there are differentiations between junk bonds and investment-grade credits. Obviously, that which can’t go on forever won’t – and it hit a brick wall.”

Spreads began to move back up from that point, eventually ballooning out to a peak level of 735 bps on Dec. 14.

A high-yield trader said that as time went on, “you kind of had a sense that [the market] might start to break down between several factors.”

One, he said, was “the inevitability of a rate hike.” The Fed statement by the end of 2014 that 2015 would in fact be the year when it would start to push rates up created an overhang on the market, with investor jitters and rate-based volatility increasing around the times of the various meetings the Federal Open Market Committee held during the year and around the scheduled release dates of monthly employment data and other statistics that participants tried to read like tea leaves to determine when the Fed would finally pull the trigger on a rate boost.

Another factor weighing on the junk market as time passed, he said, was the continually rising default rate, after several years at or near historical lows. The Standard & Poor’s trailing 12-month global speculative-grade default rate – which had ended 2014 at 1.42% – had gradually risen by more than 1 full percentage point throughout 2015, to 2.46% by the end of October, the last month for which the ratings agency had full data available.

Its U.S. corporate speculative-grade default rate had, during that time, moved up to 2.71% by the end of October from 1.59% the previous December.

The trader noted that a lot of the events of default were happening in one particular area.

“Especially in the energy space, we’ve seen companies running into trouble,” the trader said.

Energy pulls market down

It’s no secret that the high-yield energy sector – which most people think of as oil and natural gas exploration and production companies, but which also includes providers of seismic data, contract drilling services and other on-shore or offshore oilfield services, plus midstream companies that gather, process, transport and store crude petroleum, refined product, natural gas or products refined from natural gas liquids, as well as oil and natural gas competitor coal production – was in trouble even before the year began.

As noted, the root of the problem went back to 2014, when oil prices began to come down from levels topping $100 per barrel around mid-year.

According to Jodie Gunzberg, the global head of commodities for the S&P Dow Jones Indices, “in May of 2014, Russia and China struck a natural gas deal,” with Russia’s OAO Gazprom agreeing to supply 38 billion cubic meters of natural gas to China for each of the next 30 years, beginning in 2018 The deal, worth an estimated $456 billion, was 10 years in the making before the two sides finally agreed on terms.

“It seems to have acted as a catalyst for Saudi Arabia and OPEC to supply the oil market heavily to maintain their market share, to keep China as a customer. And that was the beginning of the oil price drop, and that continued.”

Thirty-eight billion cubic meters sounds like a huge amount of gas, but in the grand scheme of things, it’s actually pretty moderate – “only about the size of what New York State uses” annually, she said.

The importance of the gas deal was more symbolic – a signal that longtime rivals China and Russia are working together on energy matters, which she said might cause the Saudis and other OPEC producers to think “wait a second. If you guys are working together, does that potentially put our [China-Saudi/other OPEC producers] relationship at risk?

Gunzberg explained that this wasn’t the first time the Saudis had opened up the oil spigots all the way – they had done the same thing back in 1985, in response to different circumstances, in an effort maintain their hefty share of the world oil market, “so we’ve seen this before.”

This time around, “there have been a few variables. One is as Saudi Arabia and OPEC have supplied the market with oil, the oil price has dropped – but maybe to the Saudis’ surprise, Russia and the U.S. production didn’t really pull back. They’ve also maintained their supply. So the market is highly supplied with oil.”

From the $100-plus levels of around mid-year last year, the per-barrel price of the benchmark domestic crude oil grade, West Texas Intermediate, had plunged to $59.29 by the end of December, exacerbated by OPEC’s failure at its late-November meeting to step in and act to try and halt the slide.

Prices have continued to move mostly lower ever since then – while spiking back up to just below the $60 per barrel mark in May and June, they again reversed themselves and by mid-December were below $35 per barrel, their lowest levels since February of 2009.

The effect this has had on bonds this year has been substantial.

Gunzberg’s S&P Dow Jones Indices colleague, J.R. Rieger, the joint venture’s managing director of fixed income indices, pointed out in a year-end report that while the overall S&P 500 Bond Index was down by a modest 0.31% by early December, the energy bond sector had plunged by 5.79% on a year-to-date basis during that time. The sector consists of 10 selected energy-oriented names, most of them investment-grade corporates such as single-A issuers Conoco Philips and Halliburton Co. and BBB credits like Devon Energy Corp. and Kinder Morgan Energy Partners LP, but also including split-rated issuer the Williams Cos., Inc. and purely junk bonders Chesapeake Energy Corp. and Peabody Energy Corp.

The sector was already on the slide as the year began and then, Rieger said, “During the year, you had some small defaults, and those defaults are beginning to add up. When you look at the low default rate that we enjoyed in 2011 and 2012, and into 2013, we’re not enjoying that low default rate anymore in the high-yield segment.”

He said that “what’s driving that is the energy and energy-related companies that have all been leveraged and now are running into distressed situations. Distress is becoming very public and the default rate is something that is being carefully monitored.”

He said the recent jump in overall defaults was “predominantly driven by those recent defaults in the energy sector.”

Rieger said that at the same time that the performance of energy-sector bonds was heading downward, the cost of buying default protection on such bonds was headed in the opposite direction, shooting upward by over 150% between May 1, when the average CDS cost on the 10 bonds stood at 213 basis points, and early December, when that cost had soared to 539 bps.

Rieger likened the CDS cost increase to “the canary in the coal mine in regards to how the credit market views different issuers.”

“That acceleration of the default spread on the energy sector is extremely telling to me,” Rieger said. “It’s telling me that institutions that have exposure to energy-sector bonds are getting very anxious about the prospect of default.”

Energy overhangs 2016 market

Steve Ruggiero, the director of research at New York-based institutional broker-dealer R.W. Pressprich & Co., said that the decline of the junk market in 2015 “had everything to do with the energy trade” – part of the larger weakness in the overall commodities sector, with metals and mining and coal affected by many of the same dynamics that undermined oil.

These included too much supply versus weakened demand, particularly with the economic slowdown in China, the world’s second-biggest economy after the U.S. and previously, a voracious and seemingly inexhaustible consumer of oil, coal, metals, plastics, paper and other industrial commodities.

Heading into 2016, “those are still problematic sectors, in my opinion.”

Ruggiero cautioned that “the energy trade is a problematic one – not only because of the potential for lower oil prices, but also because of the upcoming roll-off of hedges for a number of operators.”

Many of the energy companies had prudently and presciently put hedges in place late in 2014 or early in 2015 to protect themselves against the consequences of potentially lower prices for their oil and natural gas. But now, with those hedges in many cases set to expire, “that could catalyze restructurings, more so than we’re already prepared for. So I think that’s going to weigh on the energy space.”

A key factor behind how much damage energy-sector weakness will do to the overall junk bond market is how low oil and gas prices will go, with their ripple effects on corporate revenues, cash flow, EBITDA and overall earnings.

With WTI crude prices having slid well below the $40 per barrel support level by mid-December, Ruggiero noted that “Goldman Sachs’ per-barrel target for oil is about $20 now. I’m not sure of the timeframe they’re looking at – but those are expectations by the experts.”

Moody’s Investors Service recently lowered its 2016 WTI oil price forecast to $40 per barrel from $48 previously and cut its Brent crude projection to $43 from $53; while the credit agency said that production in the United States was likely to decline, that supply would be replaced by OPEC continuing to pump in order to hold market share, continued Russian production to generate hard currency for that nation and the possible re-entry of Iranian oil to the global markets.

However, British banking giant Barclays is more bullish, believing that increased global demand will likely almost double to nearly 4 million barrels per day from 2.1 million currently, which it said would push oil’s price back up to $60 per barrel.

The energy minister of the OPEC member United Arab Emirates has also projected $60 oil by the end of 2016.

Kingman D. Penniman, the founder and president of KDP Investment Advisors, Inc. of Montpelier, Vt., sees $50 per barrel oil in 2016 and $65 in 2017. He suggested “I think we’re in a field that if you’re using a $48, or $50-, $52-type price in 2016 and you’re scurrying below $40, you do expect prices to go higher in the second half of the year. If it doesn’t? Then we start seeing very serious problems.”

But at this point, the $50 average for 2016 does mean that the price has to be approaching $60 at the end of the year. If that’s the case, then there are going to be some of these [energy] companies that are husbanding their liquidity” by cutting production and capital spending in the current low-price environment. Such companies, he said, “are going to make it.”

However, he cautioned that “if we’re looking at $50 as the new benchmark for the next couple of years, then clearly, there are going to be a lot of distressed-debt exchanges and defaults.”

Challenges lie ahead

Energy is by no means the only headwind that junk bond investors face.

Penniman said that China’s problems this past year – which caused turmoil in its own stock market over the summer, increasing volatility in other global stock and bond markets and resulting in a currency devaluation – seemed almost to have to have caught some people by surprise.

“I didn’t hear anybody talk about China at the beginning of the year,” he said.

Going into the new year, he predicted that “when we look at the significant drivers that may make high yield good or bad, China is obviously right there, as is energy, regulatory concerns and concerns about interest rates” – although he opined that the latter “are overdone.”

He said that he wished that the timing of the Federal Reserve’s mid-December 25 bps hike in its base rate “would have been a lot sooner, explaining that “we’d love stronger, higher interest rates – if it means it’s a stronger economy,” the justification the central bank offered in raising its Federal Funds target. “That’s good for high yield.”

Penniman expects that “somewhere between 3% and 5% is where we’re likely to be in 2016.”

While he puts himself “in the 5% camp, there seem to be enough indications that it could be higher, if certain things like China, or oil prices, come back.”

But until oil prices stabilize, “we’re not going to see any demand for CCC or lower-quality credits.”

A trader said that “there are so many cross currents – of government regulation, Fed intervention in the marketplace, and the downsizing of [high-yield operations of] banks and brokers. You’ve got a transition for many accounts away from doing all of their business with the banks, to looking for other counterparties. And you’ve got no economic growth, or limited economic growth.”

He said that “if people are betting on China all of a sudden turning around and starting to buy commodities again, I don’t see that happening.”

The trader continued “so people are going to be forced to deal with a lot of headwinds.”

The bottom line, he said, is that “we’re not going to see dramatic returns. I don’t think we’re going to go down by 4% or 5%, that’s for sure – but I would say total returns will be flat to 2%.

“That’s assuming there’s some recovery, some stabilization in the price of oil and industrial metals.”

He concluded “I think people would be delighted with 2% to 3%.”

At another shop, a trader foresaw an “orderly” start to 2016, “but then, I don’t know.”

He predicted little volatility, and no negative reaction to the Fed’s 25 bps rate hike. “I don’t think it scares anyone. I don’t think 25 bps is going to do a whole heck of a lot.”

But he said that “although I don’t think we have this mass sell-off where it’s mayhem, but at some point, once a couple of guys want to start taking some profits on CCC paper and single-B paper, because they think it’s just too rich, you know what will happen – it’s like a herd effect. All of a sudden, there’s another [bids-wanted] list for 20, 50, 60, 80 names. And then that starts to really change the complexion of the market.”

With 2015 on track to end in negative territory at the time of his interview, the trader projected that “we’re going to have to clean up a little bit more into the first quarter. We’re going to be behind the 8-ball moving into April.” But he added that if “we can generate a little bit of traction” at that point, a 2% to 3% return might be possible.

A more pessimistic view

Odeon Capital’s Van Alstyne doesn’t hold out much hope for a strengthening in oil prices, given that energy companies needing revenues to help service their debt, or oil-producing countries needing to generate cash, all have “a perverse notion” of continuing to over-produce, with all of them essentially hoping that the “other guys” will cut back so prices will strengthen, even as they themselves keep pumping away.

There also remains “a commodity glut worldwide,” with “the assumed buyer of last resort for the last 10 or 15 years, China,” seeming to be “not as confident now about the future as they have been,” as evidenced by its handling of its stock market and currency problems.

On top of that, he said, was the new problem that surfaced in December to spook capital markets investors – the halt to redemptions and the planned shutdown of a troubled Third Avenue junk bond fund, followed a day later by a halt to redemptions by a beleaguered Stone Lion affiliated hedge fund.

“I would think that it would be short-sighted to think that there are only two funds out there that are seeing redemptions” to that extent, he said.

With those kind of headwinds present, “there’s a chance that in 2016, you can get a positive return – but it’s going to be the strategic investor that’s not already heavily invested in the market that will get a return.”

He said he would agree with those who suggest that investors will be lucky if they make the coupon in 2016, with many seeing less than that.

A trader – expecting interest rates to continue to go up and credit spreads to widen, thinks returns this coming year will be up 5% above breakeven “if things go well – and 5% under if things go as I expect them to go.”

He anticipates that the economy “will probably continue to limp along,” but interest rates will be inching up and will put some pressure on these companies, as far as interest charges are concerned.

He thinks oil could go back up to around $60 per barrel, which he said would help the “over-corrected” energy sector.

“Maybe that’s how you get your 5%, because that’s over-corrected and does better.” But he held out the possibility that at the same time “the rest of the market does poorer – and at the end of the day, you’re pretty much at zero.”

But R.W. Pressprich’s Ruggiero sees a possibility for mid-single-digit returns in 2016, “as opposed to what we have seen this year.” Returns might reach 5% to 6%.

He allowed that “there are still going to be problems out there, but I think there’s [greater] ability for portfolio managers to outperform in the upcoming market than there has been over the last several years.

“So you can shine, or not shine – once again, it’s really the right positions and the right companies.”

What’s hot – and what’s not

But what are the right companies – or, at least, the right kinds of companies?

Ruggiero says 2016 will be “a credit-picker’s market.”

He said that “I expect that with a flattening yield curve, a flattening Treasury yield curve and continued moderate GDP growth, I’d say nominally 3%, if you spot yourself in the right sectors, which include health care, selective retailers, auto services, lodging and some consumer names, you could have some decent returns that really create alpha, per se, relative to many asset classes, not just high yield.”

Health care, he said “continues to offer value – it’s a consolidating sector that has defensive characteristics.”

Among the retailers, he suggests those “who are not entirely over-levered and who are good merchandisers with the right cost structures. It will be the one-offs that do very well, that have niches that are defensible against the Amazons of the world.”

He sees “definitely a lot of distressed opportunities now in energy, and for that matter, metals, mining and coal,” with the proviso that expiring energy production hedges must be taken into account.

One of the traders also likes energy, as well as other natural resources plays like metals and mining “that have been beaten up so badly.”

He did acknowledge that “I don’t know how low it can go – it’s been pretty well-pummeled.”

As for everything else, he called it “overpriced because everybody is trying to crowd into those other spaces.”

Odeon Capital’s Van Alstyne agrees that “you want to buy stuff that has already taken its hits.

“In energy, something like Chesapeake is a good company, it has good assets. You can make the argument that the worst is behind them in terms of market price, and there’s still potential for catalysts on the oil front.”

Conversely, he said, “the companies you want to avoid are the ones that are just hanging in there but are yet to have that other shoe drop.

“I would be looking for the stuff that’s in the headlines, that’s down 20% or 30% or 40% in the last few months. Sell the stuff that’s only down 5% or 10% to shift into stories that have already taken their hits.”

One of the traders said that “I would be opportunistic in energy, unless we’re going to go to $15 oil, which I don’t think we’re going to allow to happen. If you do your homework, I think energy has a place in any portfolio, just because it has traded off so much and some of that is technical, while some is definitely fundamental.”

He continued that “energy is probably going to be the most active sector again in 2016. So where that goes, it should have a place in your portfolio – but it can’t be for the faint of heart. There’s a lot of landmines out there.”

Away from energy, he likes retail – “people are going to buy and sell goods; I think there are some retail opportunities.”

Ditto for health care, although he says that “it could be tricky as well moving forward.”

He’s down on gaming – “I don’t see how it gets better. The competition has increased and there’s not a lot of appetite there right now.”

Likewise, he said that vehicle and equipment rental names such as Hertz Corp., Avis Budget Car Rental LLC and United Rentals Inc. are “kind of just like deadwood, the sector really doesn’t do a heck of a lot.”

Beware of energy?

Unlike some of the others questioned, KDP’s Penniman is wary of energy, declaring that “obviously, at this point, unless you’re optimistic in terms of oil prices, you’re staying away from oil, but keeping perhaps what you already have.” Commodity credits like metals, steel, coal and paper “continue to be depressed.”

He said that while auto sales “are still very strong, there’s a lot of concern that that could be the next bubble – sub-prime auto sales. So I think you have to be very selective in terms of individual credits.”

On the upside, he said that “people are looking at food [producers], they’re looking at health services and consumer products away from retail. They’re starting to look at some of the cyclical companies in the U.S. that may not be dependent on foreign exports. So I think it’s going to be that certain sectors are still OK.”

Penniman continued that “I think people feel very positive about what the outcome is with consumers, and what’s happening with the housing market too, and correlated suppliers.”

He also likes airlines, which “continue to do well.”

Companies which “have been hit hard by negative earnings surprises” could present opportunities. Such unexpected news “in this market of illiquidity” could knock a credit down by 5 or 10 points, creating an incentive to “go back and look at them carefully.” He said “we’ve seen them in media; we’ve seen them in technology; they’re across the board. There may be some opportunities there that once they’ve been hit, they may be the best individual credits.”

Another of the traders said that rather than picking what to invest in by sectors, “I don’t think you can invest this way right now – it’s a credit picker’s market, and by that I mean you have to come up with a list of credits that you are comfortable with and that either have been beaten up or are misunderstood, and put your money there.”

For instance, he said that “six weeks ago, people thought they were as safe as could be in health care – then they got their doors blown off with Valeant and since then, that whole sector had given back everything that it had gained this year.”

However, he ventured that health care “probably will come back.”

On the other hand, he does not favor retailing, feeling that “Obamacare is going to have a very real impact on discretionary spending,” citing the likely higher costs of new health care policies for many people under the law’s individual mandate.

He’d avoid cable, even though “people considered it a safe haven.” He said the bonds all got bid up, and “you’re going to see people continuing to cut the cable and getting their entertainment over the internet.” However, he said, “content providers are interesting.”

“I’m not encouraged by the regulatory environment or the global economy,” he lamented – but said that with “a little government spending, coupled with a little less regulatory pressure, credits like Transdigm, Kratos Defense & Security Solutions Inc. and B/E Aerospace Inc. “could thrive.”

He further opined that “you will be able to make money in some of the energy companies and some of the metals and mining companies – if you’re in the right ones that see some acquisition activity.”

“I would be looking for the stuff that’s in the headlines, that’s down 20% or 30% or 40% in the last few months. Sell the stuff that’s only down 5% or 10% to shift into stories that have already taken their hits.” – Mathew Van Alstyne, co-founder and managing partner in charge of research at New York’s Odeon Capital Group LLC

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