Battered Energy Bonds Spill Into Broader Corporate Bond Market
Will the Fed finally eliminate 'considerable time'?
Declining oil prices continued to weigh heavily on corporate bonds in the energy sector, pushing credit spreads in that segment of our index significantly wider. Overall, the Morningstar Corporate Bond Index widened 8 basis points to +141 last week. To put this amount of movement in context, since the beginning of 2010, the number of instances of our index widening 8 basis points or more on a weekly basis has occurred less than 10% of the time. A significant amount of those instances occurred during events instigated by the Greek debt and European banking crisis in 2012.
The most pain was realized in the energy segment, which widened 33 basis points last week. The energy sector accounts for a little over 11% of our index. The pain has been even more acute among high-yield bonds, and bonds issued by highly leveraged oil companies have been particularly hard hit. The average spread of the Bank of America High Yield Master II Index widened 70 basis points just last week alone, ending the week at +547, its highest level over the past two years. Within the high-yield index, the energy sector widened 129 basis points, ending the week at +816.
Oil prices rose in the first half of 2014, peaking at more than $107 per barrel near the end of June, and credit spreads generally tightened over the same time frame. In fact, the peak oil price for this year coincided within a few days of the tightest levels registered in both investment-grade and high-yield corporate bond indexes. Since then, oil prices have fallen almost $50 to approximately $58 per barrel. Of the price decline, 20% has occurred in just the past two weeks since OPEC surprised the market Nov. 27, when it announced that it was not cutting production. Since June 23, when high-yield spreads reached their tightest level for the year, the average spread of the Bank of America High Yield Master II Index has widened by 212 basis points. The brunt of this widening was caused by the energy sector. Over the same period, the energy sector has widened almost 500 basis points. As lower oil prices heighten the near-term default risk of high-cost oil producers and weaker service providers, investors have been selling first and asking questions later. This past week, investors withdrew more than $2.2 billion in proceeds from high-yield mutual funds and exchange-traded funds, the third-greatest amount of weekly withdrawals over the past year.
Fund flow data as of Dec. 10; spread data as of Dec. 12.
Will the Fed Finally Eliminate 'Considerable Time'?
While plunging oil prices have reduced asset values for investors, the broader population and economy will benefit from lower energy prices. The Producer Price Index declined 0.2% in November and was flat excluding food and energy. If oil stays near current levels or only rises modestly, its disinflationary effect will be felt for some time as the lower prices make their way through the value chain. Retail sales may already have begun to benefit from lower gasoline and energy prices. The November retail sales report registered a 0.7% gain, surpassing the consensus estimate of 0.4%, and October retail sales were revised higher to 0.5%. Automobile sales were a significant component of the gain as vehicle sales rose 1.7%, although even excluding auto sales, retail sales still increased a respectable 0.5%.
Even though inflation is still well below the Federal Reserve's target, with unemployment at 5.8%, close to the Fed's longer-run estimate of central tendency for unemployment to run at 5.2%-5.5%, it appears that it is getting increasingly harder for the Fed to justify keeping short-term rates at zero. In addition to the economic benefit from stronger retail sales reports, monthly payroll growth has been expanding at a rapid pace and third-quarter GDP rose 3.9%. The original intent of the zero-interest-rate policy was to be an emergency measure to support the entire financial system in December 2008, when the economy was in a free fall; it would only be kept in place during the financial crisis and would normalize soon thereafter. As such, while it's highly unlikely the Fed would begin to raise interest rates at the December meeting, we do think it will drop the language that it will maintain zero interest rates for a "considerable time."