By all indications, a price war has broken out in crude oil, a race to the bottom that tanked the stock market Monday morning, even triggering a rare marketwide trading halt. (Read: "How Trading Halts Impact ETFs.")
Plummeting crude prices reverberates well beyond the stock market, however. It also has worrying implications for high-yield bonds, a significant chunk of which comprise the debt of oil and gas companies. But bond ETF traders do have one energy-free alternative available to them.
Energy ETFs Impacted By Oil Rout
For weeks, Saudi Arabia has attempted to provide some support for crude oil prices, even as the one-two punch of the COVID-19 pandemic and one of the warmest winters on record hammered energy demand worldwide.
At Friday's OPEC meeting, however, talks between OPEC and Russia broke down. The very next day, Saudi Arabia had slashed April prices for the delivery of crude oil. (Read: "Energy ETFs Collapse As Oil Craters.")
Subsequently, oil futures prices cratered, leading to a halt in overnight futures trading. WTI crude prices fell more than 30%, down to $30.24 per barrel as of the close of Monday trading. Brent hasn't fared much better; it's now at $33.40 per barrel.
Naturally, the drop led to steep losses in energy ETFs, such as the United States Oil Fund LP (USO), down 25%; the Energy Select Sector SPDR Fund (XLE), down 20%; and the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), down 37%. (Read: "ETFs Making Moves After Historic Stock Drop.")
Big Energy Holdings In Junk Bond ETFs
The energy sector makes up a significant chunk of most junk bond ETFs as well, including the $16.4 billion iShares iBoxx USD High Yield Corporate Bond ETF (HYG) and the $7.9 billion SPDR Bloomberg Barclays High Yield Bond ETF (JNK). Roughly 12% of HYG's portfolio is in energy debt, and 11% of JNK's.
HYG was down 4.3% as of the Monday close, while JNK had fallen 4.7%.
Of all high yield ETFs, "fallen angel" bond funds, or ETFs that invest in bonds that had been rated investment grade at issuance but have since been downgraded, tend to hold the highest percentage of their portfolios in energy debt. For example, the $192 million iShares Fallen Angels USD Bond ETF (FALN) has more than 20% of its portfolio in energy junk bonds.
FALN fell 7.1% as of the Monday close.
Rising Default Risk Haunts Energy Debt
The danger now in energy debt is its rising risk of default, a specter that has actually been haunting the sector for some time.
The lower oil prices stay, the harder it will be for oil and gas companies to make money from their exploration and refinery activity; the industry's commonly cited "breakeven" point for such activity is $40 per barrel, but prices are now sub-$30.
While many of oil and gas companies have hedged their production, their hedges won't last forever, and a sustained dip in crude prices raises the risk that some of these firms will default on their obligations.
That's bad news for a sector that was already having trouble paying back its bills. Energy junk bonds defaulted at a rate of 9.5% last year, almost triple the default rate of junk bonds as a whole.
Furthermore, a recent study found that nearly 25% of energy debt was distressed as of December 2019, and thus at higher risk of default.
The Energy-Free High Yield ETF
For concerned investors, there is one junk bond ETF that doesn't have any energy exposure in its portfolio: the $33.9 million iShares iBoxx USD High Yield ex Oil & Gas Corporate Bond ETF (HYXE).
Effectively, HYXE offers the same broad exposure to the spectrum of U.S. junk bonds as HYG, just with energy excised from its holdings, and the remaining weight redistributed across other sectors.
That lack of energy exposure shielded HYXE from some, but not all, of Monday's carnage. Compared to HYG, which had fallen 4.3% on Monday, HYXE had fallen 2.9%.
Source: StockCharts.com. Data as of Mar. 9, 2020
At 0.50%, HYXE's expense ratio is only a single basis point higher than HYG's, though investors should be aware that HYXE's trading costs, such as spread, are higher.
ESG Junk Bond ETF Is Not Energy-Free
Interestingly enough, even though HYXE forgoes oil and gas exposure, it isn't an ESG ETF, precisely, because it doesn't use ESG scores or take a holistic, principles-based approach toward its security selection or weighting methodology.
The sole ESG high yield bond ETF on the market, the $51.3 million Nuveen ESG High Yield Corporate Bond ETG (NUHY), does hold some minor exposure to global energy companies. As of the time of publication, it was a little over 6%.
Contact Lara Crigger at [email protected]