One month ago, Goldman made an interesting observation: unlike the first big drop in oil prices in 2015/2016 when junk bonds, mostly those of energy companies, dropped alongside oil and in many cases decline with an even higher beta than energy equities, in 2017, the relationship had flipped, and it was HY Energy was resisting lower crude, even as stocks are sliding far more than the recent drop in oil would suggest. This is what Goldman said:
# Spot crude prices have declined by over 12% since their peak on April 11, touching levels last seen prior to the OPEC’s decision to cut production in November. The sell-off has been even more pronounced for longer-dated contracts (on a beta-adjusted basis), reflecting increasing concerns over future balances in 2018 and beyond. In the HY market, the Energy sector has again outperformed its beta to crude over the past few weeks, a pattern that is reminiscent of previous oil sell-off episodes in the second half of 2016 and early 2017 (Exhibit 3).
This outperformance also contrasts with the sharp underperformance of Energy equities since the beginning of the year (Exhibit 4)...
Why have energy junk bonds shown so much more resiliency than
equities in 2017, compared to 2015 and 2016? Again, Goldman believes it has an
answer: "We think the much stronger resilience of Energy credits
both vs. their own recent history and vs. their equities counterparts
reflects three key factors."
*) Whatever the reason for this surprising "junk" resilience, one bank believes that this skewed relationship is coming to an end.
In a note by BMO's Mark Steele titled ominously "This is the beginning of the end", the Canadian strategist warns that the breakdown of the "energy-laden HY" sector is imminent.
*Twas the breakdown in the relative strength of Energy laden Canadian stocks that foreshadowed the subsequent $10 decline in crude back on March 1st.
*Now it’s the breakdown in the relative strength of Energy laden (17% by weight) High Yield which offers the same, but ultimately much more important signaling (because it’s the higher ups in the capital structure credit market that matters) – Exhibit 2...
*If it were the end, we’d be a buyer, but as it’s the beginning of the end, in our judgement, we are continued sellers – Exhibit 3...
Many have speculated that a breakdown in junk bonds - recently hitting record tight spreads - is just the catalyst that equities have been waiting for to roll over. If BMO is right, and this is indeed the "beginning of the end" for junk, it may not be a bad time to buy some puts. With VIX back under 10, volatility has rarely been cheaper....