Oil continued to rebound this week with crude prices hitting 15-month highs as stockpiles fell more than expected.
Saudi Arabia is outwardly confident other oil-producing countries will join OPEC in cutting production, but it could be just wishful thinking. In reality, the Saudis have little choice but to cut output. Political pressures at home are building due to a lower standard of living resulting from budget cuts. The kingdom will want to boost oil prices to maximize proceeds from the upcoming initial public offering (IPO) of state oil company Aramco. Lastly, it needed send a bullish signal to investors before this week’s bond auction in order to maintain its credit rating.
To the last point, Saudi Arabia raised $17.5 billion this week in a record sovereign bond sale, eclipsing Argentina’s $16.5 billion sale earlier this year. The kingdom reportedly sold $5.5 billion worth of five-year bonds at a 135 basis point premium to U.S. treasuries, $5.5 billion 10-year bonds at a 165 basis point premium and $6.5 billion 30-year notes at a 210 basis point premium. And with oil prices stabilizing above $50 per barrel, there wasn’t any shortage of demand. Investors reportedly submitted $67 billion in bids.
The rebound in oil prices has also done wonders for the high-yield bond market, with junk bonds rallying to 2016 highs this week.
Junk bonds typically track the performance of stocks, but with equity markets largely unchanged in recent months the correlation has broken down. The rare divergence could mean one of two things: stocks could be poised for a rally or junk bonds could be set for a snapback.
At the same time, credit spreads have also compressed considerably. With oil’s comeback also boosting headline inflation expectations, analysts are once again warning about duration risk.
With investors having moved further out on the curve to capture yield, Goldman Sachs says a 1% increase in interest rates – “far from a fat tail scenario” – could trigger $1.1 trillion in losses for U.S. bondholders. Average bond maturities worldwide are more than double the inflation-adjusted level of 2009 and three times that of 1994, creating elevated duration risk. Foreign central banks and sovereign wealth funds, large buyers of U.S. fixed income, would suffer the biggest losses in the event of an interest-rate spike.
While bond buyers are facing greater risks, debt issuers are enjoying a bonanza. Sprint this week became the latest junk-rated company to sell bonds at investment-grade prices. The telecom upstart is issuing $3.5 billion of bonds at rates similar to larger competitors Verizon and AT&T thanks to some creative maneuvering. To get around covenants on existing debt, Sprint is transferring 14% of its wireless spectrum holdings to a special purpose vehicle that will then issue the new bonds. Sprint will then pay $2 billion a year to lease back the assets. By virtue of this creative arrangement, the new bonds will occupy a senior position in the company’s capital structure because lease payments would continue even in bankruptcy.
Maybe this discussion veered too far into the weeds, but it all goes to underscore the 1) rabid demand for corporate debt 2) lengths companies will go to take advantage of this historical period of rock-bottom interest rates.
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