More Troubling Energy News For Junk Bond ETFs

A big reason for the recent surge in activity (and volatility) surrounding high-yield corporate bond exchange traded funds, such as the iShares iBoxx $ High Yield Corp Bond ETF HYG and the SPDR Barclays High Yield Bond ETF JNK, is increasing concern that the junk bond market will soon be awash in a spate of defaults by energy sector issuers.

Citing Fitch Ratings, Barron's posted this ominous data point last week: “Fitch Ratings predicts in a Wednesday report that the energy sector’s default rate will surge to 11% in 2016 — higher than the 9.7% rate from 1999. It forecasts the U.S. corporate default rate will rise to 4.5% next year.” 

Oil's ongoing downward spiral is exposing cash-strapped exploration and production that had difficulty turning profits when crude was at $60 and $70 per barrel. West Texas Intermediate futures closed at $35.35 per barrel last Friday. That is one reason investors are departing JNK, the second-largest junk bond ETF in droves. And it explains why the previously anonymous ProShares Short High Yield ETF SJB is currently the talk of the junk bond ETF universe.

Inverse though not leveraged, SJB attempts to deliver the daily inverse performance of the Markit iBoxx $ Liquid High Yield Index. That is the same index tracked by HYG.

Fortunately for SJB and unfortunately for the other ETFs mentioned here, additional data points suggest more pain is coming for junk energy issues.

“Some high yield bond funds are reeling with the impact of the price of oil on energy related companies with debt.  The S&P 500 Energy Corporate Bond Index, tracking over $255 billion in debt, is down over 6% year-to-date while the overall S&P 500 Bond Index remains in positive territory.  Energy bonds have been less volatile than the stock of these companies but a 6% drop is painful for bond investors,” said S&P Dow Jones Indices Managing Director and Global Head of Fixed Income J.R. Rieger in a recent note. 

Indeed, the six percent year-to-date loss by the S&P 500 Energy Corporate Bond Index is a lot better than the 22 percent shed by the Energy Select Sector SPDR ETF XLE. XLE, the largest equity-based energy ETF, is the worst performer among the nine established sector SPDRs by a wide margin this year. However, it should be noted the S&P 500 Energy Corporate Bond Index debuted in July, implying that if the benchmark had been around all of this year, its losses would be much more significant. 

Ominous is the rising cost of energy issuer credit default swaps traders use to guard issuer default.

“More telling is how the credit markets are viewing the cost of buying default protection on the debt of energy related companies.  The cost of buying default protection has risen by 185% since May 1^st, 2015 indicating the credit markets are expecting more distress in the sector over the near term.  Based on the index the cost per $100,000 of protection on May 1, 2015 was $2,130 and the cost per $100,000 of protection on December 10^th was $6,080,” adds Rieger.