Junk bonds sold by energy companies boosted by oil surge

Investors are demanding less compensation to take on the risk of lending to junk-rated energy companies as commodity prices surge and industry executives eschew the drill-at-all costs mentality that sparked a crisis eight years ago.

The additional borrowing costs investors require to hold the debt of lowly rated energy companies over US government bonds has fallen from above 4 percentage points in March to 3.65 percentage points this week, according to an Ice Data Services index that tracks trading activity in the US debt market.

The decline has pulled the “spread” on junk-rated energy bonds below that of the broader high-yield market — something that has not occurred on a sustained basis since the US energy industry crisis that began in 2014.

A glut of supply caused by a surge in production among US shale drillers and weakening demand prompted by slowing Chinese economic growth sent oil prices collapsing between mid-2014 and early 2016. The oil price plunge set off a wave of defaults among US energy exploration and production companies, many of which financed their drilling through borrowing in the junk bond market.

“Company behaviour has changed,” said Ken Monaghan, a high-yield portfolio manager at Amundi US. “Energy companies are paying down debt instead of following the ‘drill baby drill’ mantra.”

The fiscal discipline combined with higher oil prices have prompted a rapid turnround for the market, with energy bonds having traded with spreads around 12 percentage points more than the rest of the market, on average, during the worst of the pandemic induced sell-off in March 2020. The additional spread above the wider market had also peaked around 11 percentage points during the energy crisis in 2016.

Monaghan also said he expects some energy companies to be upgraded from high-yield to investment-grade soon, with companies like Occidental Petroleum that slipped down the ratings ladder during the pandemic expected to climb back up it.

JPMorgan expects $68bn worth of North American energy-sector debt to be upgraded from junk to investment grade through 2023, leaving the industry as the biggest contributor to the Wall Street bank’s list of “rising stars”.

These companies are currently helping to improve the overall quality of the debt in the junk bond market, as they share more attributes with high-grade borrowers than the ones that are more common on the lower side of the ratings scale.