Photographer: Nadja Brandt/Bloomberg

Junk Bond Indexes Are Getting Junkier

Downgrades are changing debt benchmarks.

Welcome to the great credit rating migration of 2016.

It comes in table format, courtesy of CreditSights Inc. 

Source: CreditSights

As ultra-low oil prices have forced a quick reevaluation of the energy sector's fortunes, credit rating companies have been downgrading energy companies, including Chesapeake Energy Corp. and Whiting Petroleum Corp. The downgrades have fed into the high-yield bond indexes often used by investors to benchmark their returns.

The trend means some $28.6 billion worth of energy-related debt has left the BBB and B-rated buckets of the Bank of America Merrill Lynch High-Yield Bond Index, migrating into the lower-rated BB and CCC brackets instead, according to CreditSights. Basic industry, which includes many mining companies, also saw a relatively big migration, with $21 billion leaving the BBB category.

"It is no surprise that a turn in the credit cycle starts to shift the industry mix as companies see downgrades outpace upgrades," said CreditSights analysts Glenn Reynolds and Nathan Wenger. "As we get closer to the end of year seven of the credit cycle, the reality of rising defaults and distressed exchanges ahead necessarily will be flowing into pricing of what could be a protracted default cycle but with 2016-2017 seeing energy and basic industry getting an early start to the pack."

While the jump in the lowest-rated CCC tier has been strong, on a market value basis things look rather different. The divergence between face and market value "provide[s] a stark reminder of how far market values have plunged," CreditSights noted

Source: CreditSights

With junk bonds rallying strongly in recent days, it's possible that the gap has narrowed, though the volatility associated with the move is unlikely to be of much consolation to whipsawed junk bond investors.

"In looking back across the default cycles for the market value swings, however, it is important to note that the shifts can come on suddenly to the upside in the overall index," CreditSights wrote. "Timing that perfectly can be very much a challenge. ... When such a wide cross-section of issuers turn on such similar macro variables (OPEC supply, China demand, central bank policies, etc.), the price swings can be treacherous."

Indeed.

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