Our U.S. bond strategists have made the case to remain overweight credit until monetary conditions become excessively restrictive, which is anticipated to be at least a couple Fed rate hikes away. In the meantime, there are two non-trivial risks that could cause temporary harm to long credit positions.
Last year’s dramatic collapse in the price of oil set-off a minor panic in the corporate bond market. Spreads widened significantly, and the pain was not limited to energy related credits. While fundamentally there is no reason that lower oil prices should raise questions about the creditworthiness of non-energy related firms, fund outflows are likely responsible for a good portion of the observed contagion, at least in the high-yield space.
If our commodity strategists are correct that oil prices have overshot to the upside, then oil price downside poses a major near-term risk to corporate bond spreads. To gauge the potential magnitude of this risk, we calculate the trailing 26-week beta between changes in corporate bond spreads and the price of Brent crude oil (Table above).
Assuming that the calculated betas remain unchanged and that the Brent price falls to $50 over a six month period, high-yield energy sector spreads have the greatest sensitivity to oil prices, followed by non-energy high-yield spreads, investment grade energy spreads and non-energy investment grade spreads. This exercise assumes that betas remain unchanged, which will probably prove to be an overly pessimistic assumption. In all likelihood any renewed oil price shock will not be as severe as was witnessed in 2014, and fund outflows are unlikely to be as dramatic. A strategy of avoiding energy names in both investment grade and high-yield corporate bond markets is sufficient to mitigate the potential shock from another downleg in oil prices.
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