Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Last year's junk-bond sell-off seemed scary for a moment. Losses accelerated, funds collapsed, defaults mounted.

But something remarkable happened on the way to a destabilizing rout: Oil prices stabilized and investors piled back into the notes they had just abandoned. Everything was suddenly just fine again (with the exception of a few companies and investors that got annihilated along the way).

And just like that, energy junk bonds were enticing again. Investors have been so eager to get their hands on such dollar-denominated debt that they pretty much forgot about the 23 percent plunge in the last five months of 2015. They're now demanding the smallest premium relative to the broader index since last August, when the high-yield debt sell-off really accelerated.

What Risk?
High-yield bond buyers are demanding the smallest premium to own energy debt since August
Source: Bank of America Merrill Lynch index data

High-yield bonds of energy companies have gained 16.2 percent so far this year, recovering an estimated $21.5 billion of market value. While energy junk bonds accounted for a shrinking proportion of the U.S. high-yield bond index last year, they have been a growing part of the market this year, now accounting for 13.8 percent of the broader benchmark, up from 10.9 percent at the end of 2015.

Creeping Up
Energy debt is coming back up as a proportion of the overall junk-bond index
Source: Bank of America Merrill Lynch index data

Everyone now seems to love these companies again except for one big constituent: the biggest Wall Street banks. These firms got close enough to the fire that they don't want to take that risk again. They have significantly reduced their potential losses by curtailing credit lines to energy companies this year by about 19 percent through April 20, according to Bloomberg Intelligence analyst Spencer Cutter. Some companies, including W&T Offshore, Stone Energy and Midstates Petroleum, found themselves effectively overdrawn after their lenders cut their credit lines, his research shows. 

It seems as if the banks are right to be cautious here. They're looking at the individual companies, assessing their specific risks and deciding they don't want so much exposure to them. Bond buyers should follow the banks' lead in exercising restraint when considering energy junk.

This latest rally has gone a bit too far. Yes, oil prices have rebounded to $48.4 a barrel from as low as $26.2 in February, but riskier energy companies are still defaulting at an accelerating pace. It wouldn't take much to push more of them to the brink. 

Feeling Low
Despite the recent recovery in oil prices, they're still low relative to recent years
Source: Bloomberg, New York Mercantile Exchange

While some investors saw value in these notes at the end of last year and early this year, the current bid appears to be coming more from a general shift in sentiment back toward high-yield bonds. Yields are poised to stay historically low worldwide for the foreseeable future, so institutions and individuals are piling back into speculative-grade notes. After all, the average yield of 7.9 percent on U.S. junk bonds looks incredibly appealing when juxtaposed with trillions of dollars of negative-yielding debt. 

But peel back the hood and this market is filling up with energy debt once again. Oil markets have proved to be incredibly difficult or even impossible to predict. It's unlikely that prices are going to head back above $100 a barrel anytime soon, or, if Norway's energy minister is right, ever. He thinks that $60 is a more reasonable price. But many of the oil and gas companies that borrowed billions of dollars in recent years were counting on much higher crude prices, which are unlikely to materialize in the near future. 

So unless bond buyers are happy shutting their eyes and throwing their money into a pool of unknowns, they would be wise to look at what they're buying with a more discerning eye.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net