The chart above shows investment grade credit spreads as measured by the Merrill Lynch Corporate Master Index, as of Dec. 11th. Spreads are somewhat elevated, to be sure, but they are not even close to the distressed conditions we saw in late 2008. They are about the same today as they were before and during the 2001 recession, which was the mildest on record.
High-yield credit spreads are significantly higher than investment grade spreads, but the difference between HY and IG spreads (shown in the second chart above) is still significantly shy of what we have seen during genuine periods of economic and financial distress.
Once we drill down to the energy sector of the HY market, however, we see the main source of today's market angst. The market value of HY energy bonds has dropped fully 30% from the highs of mid-2015, which was just before oil prices started to collapse. Crude oil futures are now down to $35 per barrel or so, which is a long way from the $110+ prices which prevailed during the first half of last year.
Here are some relevant statistics: Energy-related HY corporate bonds represent about 15% of the HY debt market, but the losses in this segment represent about half the losses of the entire HY market. That implies that losses on non-oil HY bonds are only about 6%.
The chart above shows the price of HYG, which is an ETF that targets the liquid bonds in the iBoxx HY Index. Note the massive increase in trade activity last week, when more than 54 million shares traded hands on Friday, as compared to 10 million or so daily during a normal week. This has all the earmarks of the panic selling described in a recent WJS article. Investors trying to escape the damage in the oil patch have triggered a wave of selling that has affected the entire HY sector.
But there's one thing missing from the "panic" story. Swap spreads, shown in the chart above, are not displaying any signs of distress, either here or in the Eurozone. Swap spreads are relatively low and stable, which means that liquidity conditions in the financial markets are normal. Large institutional investors can buy and sell risk easily, and in quantity, without having to pay high prices to do so. Swap spreads say that systemic risk is low, which is another way of saying that the distress in the HY market and in particular in the oil patch has not proved contagious to the larger economy. This is very different from the situation in 2008, when the distress in the housing and in particular the MBS market did prove contagious—and highly so.
Systemic risk also fails to appear in the prices of gold and 5-yr TIPS, as the chart above shows. The prices of both of these safe-haven assets have been on a declining trend for several years. If things were really falling apart, the two lines in this chart would be headed skywards. But they're not.
Collapsing oil prices have already resulted in a two-thirds decline in the number of active oil drilling rigs in the U.S., so we know that the current glut of oil supply is on its way to reversing, and in time oil prices will firm. Lots of money has been and will be lost in the oil patch, but even today the losses that have been registered in oil-related energy debt are quite small, on the order of $60-65 billion. That's a drop in the bucket of U.S. asset markets, and a very tiny fraction of the $80 trillion of net worth that resides in the U.S.
This is not a time to panic, it's a time to find value outside the oil patch. It's one more "wall of worry" that we're likely to leave behind.