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Why Is High-Yield Energy Debt Decoupling From Oil?

Pipelines

The recent drop in crude oil prices has not reflected in the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG), as shown in the charts below. Various analysts believe that the close correlation between the junk bonds and crude oil—which have been together for quite some time—has now decoupled.

Is this relationship really over, or is this parting of ways only a temporary separation?

(Click to enlarge)

During the start of 2016, oil was falling into a seemingly bottomless pit—fears regarding the solvency of a number of companies pulled the prices of junk bonds down with it.

But between February and June, oil prices rallied to over $50 a barrel, and the high-yield bonds followed suit, refusing to be left behind.

The oil producers managed to survive the first-half of 2015 due to existing hedges, but during the second-half of the year, and in early 2016, expiring hedges and low crude oil prices took its toll and led to record bankruptcies.

However, the rally to $50 a barrel levels was a Godsend, and the oil producers have ramped up their hedges.

A Reuters analysis of disclosures reports that 17 of the 30 large U.S. shale producers have increased their hedges—the most since 2015.

“The producers have sold the hell out of this rally,” said Stephen Schork, president of Schork Group Inc., a consulting firm in Villanova, Pennsylvania. “The companies that did survive, they’ve been hedging into this rally. And they’re counting their blessings,” reports Bloomberg.

In the last few weeks, oil is again back into a bear market, dropping below $40 a barrel on Monday; however, the bonds have yet to fall in the same proportion. Related: Oil Spikes After EIA Reports Significant Draw To Gasoline Stocks

“That portion of the high-yield market especially, it looks a little rich with crude at $40," a barrel, Rogoff, head of global credit strategy research at Barclays Capital, said Monday on Bloomberg TV. "If we drop below, you’ve probably got some downside there."

The recent fall in crude has retraced almost 50% of the total rise, which is considered healthy by technical analysts, as it corrects the froth that builds in any rally and shakes out the weak hands. After all, crude had a steep rally from its lows without any significant pullbacks.

However, if crude continues to trade below the $40 a barrel mark, it will flash red signals.

According to Fitch, 17% of the $1.5 trillion total high-yield bonds are with the energy sector, and in 2016, the trailing 12-month default rate for the energy sector is up to 16%, reports Investopedia.

Oil companies are not completely out of the woods yet. Two more energy companies filed for voluntary Chapter 11 bankruptcy petition and a pre-packaged debt restructuring plan, which shows that a few companies continue to face challenges even at higher crude oil prices. Related: Powering The Internet Of Things

Credit rating company S&P also expects default rates in the companies it rates as high yield to triple from levels seen two years ago, reports Financial Times.

Many companies have taken steps ahead of the fall anticipating a double dip. However, if prices remain lower for longer, we will see a wave of defaults hit the energy companies again, and the high-yield bonds will track the crude oil prices lower.

On the other hand, if prices quickly bounce back and trade in the higher range of $45-$50 a barrel, the companies should avoid large scale defaults, which should keep the bonds decoupled to a certain degree.

By Rakesh Upadhyay for Oilprice.com

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