A Bifurcation in High Yield Defaults

June 09, 2016

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May. These defaults are defined as missed coupon payments, missed principal payments, bankruptcy filings, or distressed exchanges. Notable May defaults include Linn Energy, SandRidge Energy, Midstates Petroleum, Breitburn Energy Partners, and Penn Virginia.

The default rate of the overall high yield index is now 5.2%, as shown by the blue line in this week’s chart. The default rate has recently risen due to more defaults in the high yield energy and metals/mining sectors. Defaults of issuers in that space now stand at 17.8%, as shown in the red line. Meanwhile, excluding energy and metals/mining, the default rate is at pre- and post-crisis lows, at 1.7% as shown in the green line. This bifurcation means that while the energy and metals/mining sectors have suffered from low oil and metals prices, the rest of the economy — healthcare, technology, financials, etc. — have performed as well as ever, at least in terms of how defaults can reflect performance.

The 5.2% overall high yield default rate and the 17.8% high yield energy and metals/mining issuer default rate confirm our previous paper about expected defaults for the year. Based on March-end spreads as a measure of the market’s expectation of defaults, the market was implying a default rate of 4.77%. The range we provided was 4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 10%, to 6.2% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 30%, to 8.4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 50%. With the steady rise in the price of oil, we would be surprised to see the high yield energy and metals/mining issuer default rate reach as high as 50%, which should eliminate the worst case scenario for high yield investors. Of course, capital markets are dynamic and can change unpredictably, so we will continue to monitor this trend.