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The collapse in oil prices has created a ticking time bomb in the energy markets.
You see, fueled by the market's easy money policies, a big portion of the expansion in the energy markets has been financed with high-risk "junk" bonds.
According to the latest estimates, energy-related issuances now account for almost 15% of the total $1.4 trillion junk-bond market. That's roughly $210 billion in high-risk debt.
As you might have guessed, the vast majority of these high-yield bonds were used to fund oil and gas deals.
Now a wave of credit rating downgrades is hitting the sector as oil prices reset at lower levels.
That has created a dangerous environment for both oil companies and bond investors….
Big Debts, but Not Enough to Pay
Here's why: If oil prices stay low enough long enough, some of the weakest issuers in the junk bond space are bound to run into cash-flow issues.
That's why the high-risk end of the bond curve is currently overvalued by anybody's standards.
As Martin Fridson of Lehmann Livian Fridson Advisors noted about the high-yield space yesterday on Barrons.com, the difference between fair value and his option-adjusted spread (OAS) model had increased by a whopping 163 basis points (bps) or 1.63% since January 31.
That's more than the one standard deviation Fridson has identified as the "cutoff for defining an extreme."
According to Fridson, the "current overvaluation of high-yield bonds reflects investor complacency engendered by the Fed's lifting and stabilizing of financial markets with an unreasonably easy money policy."
In all, the OAS fair value for the high-risk portion of the bond curve is now 616 bps. The energy component of that, however, stands at 688 bps.
Of course, high-yield bond funds are an easy way to access the junk bond market.
These are usually exchange traded funds (ETFs) that can be purchased and sold as easily as regular stocks. They provide monthly or quarterly dividends that are well above market averages.
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.