Bank of America: We Won't Know What's Going On With Energy Debt Until Investors Come Back From Vacation
This time, the energy sector is their battleground.
Worries about contagion stemming from high-yield bonds have been at the forefront of investors' minds in recent weeks, as any negative effects that ripple into the investment-grade market would presumably also bode ill for stocks.
In a research note, Bank of America Merrill Lynch credit strategists Hans Mikkelsen and Yuriy Shchuchinov note that the widening in investment-grade credit spreads has overshot the weakness in corresponding stocks:
Is this a case of bonds pointing to further weakness in credit, or is the softness isolated to this asset class for now?
The strategists lean toward the latter option. The duo chalks up this weakness in credit by blending two of Wall Street's favorite explanations for presumed aberrations in price action: seasonality and liquidity.
"Our view remains that the recent plunge in high-grade energy bonds was exacerbated by the pre-end of the year holiday season lack of liquidity in the corporate bond market," write Mikkelsen and Shchuchinov. "In fact we would argue that a lot of investors have more or less closed up shop for the year, and hence shorting activity by hedge funds and other investors had outsized impact on bond prices."
Dedicated, long-only energy investors weren't dumping their positions en masse amid this recent downdraft, the strategists believe.
In other words, with many investors gone for the holidays, hedge fund hijinks ensued. Think of it like Home Alone without Macaulay Culkin around to keep the criminals in line: If Harry and Marv had their way, the McAllister's house would've been robbed and flooded while the family was away for Christmas.
Investors have clearly been rewarding quality in the energy group: Spread ratios between high-yield and ivnestment-grade energy bonds are far higher than for the market as a whole. This dynamic may have made a compression trade look more tactically attractive. Historically, positions broadly characterized as convergence trades have proved profitable as relationships reassert themselves over a long-enough time frame. (The strategy isn't without it's mega-losers, however, with the most infamous being the demise of Long-Term Capital Management).
Once the stronger hands return to the market in 2016, the strategists think we'll be able to get a cleaner read on just what's transpired here:
Going forward – and especially after New Year’s – either real money accounts reevaluate their positions and sell bonds to support the price action dictated by short sellers, or they buy bonds to allows credit spreads to retrace the part of the widening that was due to year-end illiquidity. Or something in-between. Our view is that the gap between Oil & Gas sector debt and equity valuations reflects to a large extent the yearend relative lack of liquidity in the corporate bond market, and that credit will improve and narrow the gap (depending on the issuer specific credit stories).
Until then ...¯\_(ツ)_/¯.